India Bonds Curve Flattens as RBI Drains Liquidity

The central bank has already withdrawn more than 1 trillion rupees, or about $10.4 billion, and traders say further liquidity absorption will determine how much more the curve flattens. ICBC and Anand Rathi Global Finance both expect the five-year to 10-year yield gap to narrow, while ICICI Securities Primary Dealership sees the five-year yield rising toward 7% from 6.94% if the RBI stays aggressive. That would leave the short end more exposed than the 10-year, particularly if overnight rates are pushed closer to, or even above, the repo rate.

This is less about a broad repricing of Indian growth and more about policy transmission. The RBI has been draining excess liquidity because surplus banking-system cash has kept overnight rates below the policy rate, diluting the effect of previous tightening. By absorbing funds, the central bank is trying to force money-market rates back toward the repo rate and keep inflation pressures in check. The next policy meeting, where economists broadly expect a 25-basis-point hike to 5.50%, will be crucial. Any guidance that points to more increases would likely hit the front and belly of the curve harder than the 10-year.

That is why some investors are already positioning for a flatter curve. Anand Rathi recommends selling the five-year benchmark and buying the 10-year bond, a trade that benefits if the yield gap narrows further. The bull case for the 10-year is that it offers comparatively better carry if the RBI focuses on liquidity management rather than a prolonged rate cycle. The bear case is that if the central bank surprises with a more hawkish path, the entire curve could sell off, with the five-year still underperforming most.

The backdrop is not supportive for risk assets more broadly. Rising US Treasury yields and a firmer dollar have tightened global financial conditions, weighing on emerging markets including India. That has already fed into domestic equity weakness and foreign outflows, while the bond market faces the additional drag of central-bank liquidity withdrawal. For fixed-income investors, the key question now is not whether rates are high, but where the curve stops steepening and starts flattening enough to make duration trades meaningful again.

If the RBI keeps draining cash at the current pace, the next move in India’s bond market is likely to be less about outright yield direction and more about relative-value positioning. The 10-year bond may continue to outperform the five-year note, but only so long as policy tightening remains measured and the central bank avoids pushing short-end rates decisively above the repo rate.