Government Bond Curve Bull Steepens On RBI’s Note Move

Indian government bonds bull steepened on Monday, with the belly leading the bid as the major cash benchmarks finished 1-8bp richer.

• This came after a late Friday announcement from the RBI in which it outlined its decision to remove INR2,000 bank notes from circulation (click for full details)
• The general take from the sell-side points to more of a meaningful liquidity impact, particularly in the short- to medium-term, as opposed to any structural feedthrough into inflation. Meanwhile, most were quick to pushback against any ideas that the move should be linked to the demonetisation efforts of ’16 in any manner.
• The net liquidity impact on the deposit front will ultimately be a trade-off between the proportion of INR2,000 notes exchanged for lower denomination currency vs. the proportion of INR2,000 notes deposited at banks.
• Any meaningful deposit growth could result in a steepening bias on the INR government bond curve, although some have outlined a degree of caution when it comes to the lasting impact of any such move. This is because bank holdings of fixed income assets already top levels required by regulators, in addition to the potential for diminished expectations re: RBI liquidity injections given the decision on INR2,000 notes.
• Overnight call rate dynamics will also be eyed in the coming days, given some recent spikes higher in that rate which cleared policy rate levels and, in some instances, even breached the interest rate applied to the RBI’s Marginal Standing Facility.