India rates continued to sell off this week as a broader tightening impulse began feeding through the rates market. Beyond the 25bp hike delivered at last week's MPC, a broader tightening impulse is feeding through the rates market, with further OMO sales conducted on Tuesday and tighter CRR maintenance requirements set to take effect from Friday. The repricing has been particularly acute at the front end. Since early September, 2Y IGB and OIS yields have risen by around 65bp and 39bp respectively as investors reassess the likely extent of policy tightening. The front-end selloff has frontrun policy rate tightening, resulting in a continued widening of the 2Y IGB-policy rate spread. We saw this dynamic during the early stages of previous RBI tightening cycles as well.
The selloff has not been confined to the front end. The belly and long end have also come under pressure, albeit to a lesser degree. In addition to OMO sales weighing on the belly, the RBI announced a switch auction yesterday to convert INR200bn of short-dated bonds into longer maturities, extending duration supply into the 2033-2060 segment of the curve. While such operations are not unusual, they could amplify pressure on longer-dated yields in the current environment. The recent selloff has also driven a widening in IGB-UST spreads across maturities in recent sessions, bucking the broader trend of spread compression seen in regional economies.
The near-term direction of IGB yields remains skewed higher as the RBI continues to tackle inflation risks, excess liquidity and currency stability concerns. While the front end remains most exposed to policy repricing, upward pressure is unlikely to be confined there. OMO sales continue to weigh on the belly, while greater duration supply is adding pressure further out the curve. Taken together, the policy and supply backdrop suggests yields could remain under upward pressure in the near term. Against this backdrop, we have revised our INR rates forecasts higher. Even after incorporating this upward revision, we think risks remain skewed towards higher yields should markets continue to price a more aggressive tightening cycle.
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