Money market swings dilute the promise of an easy policy

Mumbai: A week after the Reserve Bank of India (RBI) announced its intention to lift overnight market interest rates toward its policy rates, the money market is in disarray. Almost every rate appears to have been affected — except the overnight rate.

The decision to suck out Rs 2 lakh crore in a 14-day reverse repo auction last Friday came in ahead of market expectations and the manner in which it was communicated soon after a warning about financial stability spooked investors. A reverse repo is where banks, which don’t find avenues to lend, park excess funds with the RBI and earn interest.

Furthermore, the RBI move to take excess funds from banks at a peak yield of 3.55 per cent Friday, 20 basis points above the reverse repo rate, has left bond traders scrambling to figure what the central bank would do next. A basis point is 0.01 percentage point.

“If the RBI’s intention is to suck out the excess liquidity gradually, they may have started the process actually,” said Vijay Sharma, executive vice-president for fixed income at PNB Gilts. “However, if the intention is to bring the overnight rates within the LAF (liquidity adjustment facility) corridor, they may want to do more of the same. Only then the other overnight rates such as TREPS would move toward call money rates.’’ TREPS is a tri-party repo market where non-banks and banks lend and borrow overnight.

Bond Yield Surges

The yield on the benchmark 10- year bonds has jumped 10 basis points to 5.99 per cent since the central bank said it is returning to ‘restore normal liquidity management operations’.

Yields on short term treasury bills have also risen between 17 and 24 basis points across maturities. Call money rate last Friday ranged 1.9 per cent to 3.5 per cent, the same as a week before.

Overnight rates falling to a low of 1.90 per cent in the Tri-party Repo market and call money rates at less than reverse repo rate raised concerns of financial instability. So, the RBI wanted to take baby steps to correct the abnormality without a shift in its commitment to easy liquidity for sustained economic recovery. The markets anticipated the first steps in March when the cut in Cash Reserve Ratio expires. But RBI’s January 8 communication conveyed a message that it is the beginning of tapering and other measures could follow soon.

“On a review of evolving liquidity and financial conditions, it has been decided to restore normal liquidity management operations in a phased manner,” RBI said in the communication. This, coupled with yields of 3.55 per cent in last Friday's reverse repo, has sent mixed signals.

These have pushed the market in the opposite direction of what the Monetary Policy Committee and the RBI itself wanted. After the erratic moves in yields, the Governor sought to calm the nerves over the weekend. “I would like to unambiguously reiterate that the Reserve Bank remains steadfast to take any further measures, as may be necessary,” to ensure recovery, Governor Shaktikanta Das said at the Palkhivala Memorial Lecture.

Due Last Year

To be sure, what the RBI is doing is to get back to what should have happened in the first quarter of 2020 but got pushed because of the Covid -19 situation.

“RBI’s latest measure is simply the reintroduction of a previous liquidity framework that had been suspended to provide market participants with more flexibility in light of Covid disruptions,” said a debt fund manager. “However, since the reintroduction coincides with a phase when the market was expecting some reversal measures, there may have been some mixups in signals received.”

Apart from the money market operations, the central bank may have to correct the distortions in the currency market, which is primarily responsible for the excess liquidity. The one-year forward premium rate is too high compared with domestic rates.

“The rupee forward rates are quite high because of RBI’s intervention in the market,” said a bond trader. “It needs to do a lot more like invoking the MSS (market stabilisation scheme), Standing Deposit Facility, and other things to suck out liquidity and get forward premium down.”

The one year forward premium is at 5.1 per cent, including the LIBOR rate, compared with 1-year Treasury yields at 3.56 per cent.