RBI Move to Drain ₹1 Lakh Crore from Banking System Sparks Bond Selloff as 10-Year Yield Hits 7.08%

Domestic bond markets have entered a sharp downturn as the Reserve Bank of India (RBI) initiates aggressive measures to absorb surplus liquidity from the financial system. The central bank's announcement that it will drain ₹1 lakh crore ($10.5 billion) from commercial lenders through open-market operation (OMO) bond sales has sparked widespread concern among debt traders over an extended slump in sovereign paper.

The benchmark 10-year government bond yield climbed to 7.08%, with primary dealers and institutional desks warning that yields could revisit and breach previous peaks. The bond sales are structured across three tranches, with the initial tranche offering paper maturing in three to six years.

Liquidity Glut Meets Resurgent Price Pressures

The RBI's intervention marks a sharp shift in liquidity conditions. In preceding weeks, the central bank had drawn an unprecedented $127 billion from the Indian diaspora via special deposits to shore up foreign exchange reserves and cushion the rupee. Those inflows swelled the banking system’s liquidity surplus to an all-time record of roughly ₹11 trillion ($115 billion).

While that cash pile had temporarily insulated local debt from higher yields in global bond markets, resurgent crude oil prices and accelerating domestic consumer inflation—edging closer to the upper boundary of the RBI's 2% to 6% target band—prompted the monetary authority to act against liquidity-fueled price pressures.

Five-Year Paper Takes the Heaviest Hit

The selloff has been particularly acute in the belly of the sovereign yield curve:

• The yield on five-year government bonds surged by 21 basis points in a single session, marking its steepest single-day rise since May 2022.
• By contrast, the 10-year benchmark rate increased by 6 basis points, reflecting an initial underperformance at the short end.
• The 6.94% bond maturing in 2036 saw yields climb by 7 basis points to 7.09%, while yields on the 6.36% note due in 2031 jumped 16 basis points to 6.78%.

VRC Reddy, Head of Treasury at Karur Vysya Bank Ltd., noted that the central bank's step represents its most stringent intervention yet, with the richly valued five-year segment bearing the primary impact. Reddy indicated that the yield curve may steepen further as short-end yields rise, with the spread between five- and 10-year yields likely stabilizing between 20 and 30 basis points.

Analysts Escalate Rate Hike Projections

Underwriting institutions and global brokerages have swiftly recalibrated their yield and policy outlooks:

Key Institutional Forecasts:

• ICICI Securities Primary Dealership and IDFC First Bank: Both institutions expect benchmark 10-year yields to test their earlier peaks and potentially climb to 7.25% by December 31, which would mark the highest level in three years.
• Citigroup: The investment bank advanced its timeline for RBI policy tightening, bringing forward expectations for a repo rate hike to October from December. Citigroup projects cumulative rate hikes of 50 to 75 basis points during the unfolding cycle.

Supply Pressures and FPI Outflows

Compounding the liquidity withdrawal is the substantial borrowing calendar for the second half of the fiscal year. The central government is scheduled to raise nearly ₹8 lakh crore over the coming six months, a window that coincides with elevated seasonal debt issuance from Indian states.

Foreign portfolio investors (FPIs) have simultaneously trimmed exposure. Offshore funds sold ₹2,470 crore of index-eligible Indian government bonds following an outflow of ₹4,730 crore late last week, adding to the headwinds confronting primary dealers and bond desks. With liquidity draining and heavy debt supply looming, domestic fixed-income markets appear set for a protracted phase of elevated yields.

Tags: Reserve Bank of India Indian Sovereign Bonds ICICI Securities Primary Dealership IDFC First Bank Karur Vysya Bank Citigroup