Treasury Bill yields soar over tighter liquidity, inflation worries

Yield curve flattens; T-bill, 10-year bond spread now at 16 bps versus 222 bps a year ago

Reflecting tighter liquidity conditions in the banking system and growing unease about persistently elevated inflation, yields on treasury bills issued by the government have skyrocketed over the past couple of weeks.

The government sells T-bills of three maturities – 91-day, 182-day and 364-day – on a weekly basis to take care of its short-term borrowing requirements. Given the short-term nature of these instruments, they are highly sensitive to liquidity conditions and near-term interest rate expectations.

Since February 1, cutoff yields on 91-day, 182-day and 364-day T-bills at weekly auctions have jumped 26 basis points, 25 bps and 28 bps, respectively, Reserve Bank of India data showed. If one takes into account the movement so far in the calendar year, the rise is starker.

Since the last T-bill auction in 2022, yields on 91-day, 182-day and 364-day T-bills have risen by 51 bps, 44 bps and 37 bps, respectively.

Apart from leading to a rise in sovereign borrowing costs, the surge in T-bill yields has broader implications, given that government securities are the benchmarks for pricing debt issued by private players. T-bill yields are also one of the external benchmarks used by banks for pricing loans.

The two key reasons behind the movement in T-bill yields are a significant tightening in banking system liquidity and an abrupt reset of the market’s interest rate outlook, caused by a higher-than-expected domestic inflation number in January.

While month-end tax outflows were the immediate trigger for tighter liquidity, the maturity of a total of Rs 75,000 crore of long-term repo operations from February to April is also seen adding strain to liquidity.

“The T-bill cut-off yields in Wednesday’s auction were higher than the market had anticipated, because of the liquidity conditions and the interest rate outlook. Moreover, the Budget announced Rs 50,000 crore of extra short-term borrowing, so all-in-all, T-bills are facing a problem right now,” Naveen Singh, head of trading at ICICI Securities Primary Dealership said.

“We are witnessing a flatter yield curve here and there is a possibility that there could be stronger inversions later. The global data suggests that central banks will have to engineer growth slowdowns to bring down inflation, so yield curves could flatten in an unprecedented way,” he said.

At present, the gap between the 364-day T-bill yield and the 10-year government bond yield is a mere 16 bps as against 222 bps the same time last year. The quicker rise in short-term debt yields reflects concerns over more rate hikes, while the anchoring of long-term bond yields reflects concerns of weak economic growth over a larger time frame, analysts said.

Over the past year, surplus liquidity in the banking system has reduced considerably as the RBI has been focused on withdrawal of policy accommodation as it seeks to battle high inflation. From a surplus of around Rs 7 trillion in April 2022, the excess cash shrunk to around 1.6 trillion rupees in December-January, if one goes by the surplus funds deployed by banks with the RBI.

Over the last twelve working days, the RBI has been injecting funds into the banking system, implying tight liquidity conditions have prompted banks to borrow from the central bank’s Marginal Standing Facility (MSF) window. The MSF rate is 25 bps higher than the repo rate, which is currently at 6.50 per cent.

On February 21, the central bank injected Rs 71,659.08 crore into the banking system. The last time the RBI was infusing funds of a similar quantum was in October 2022. The impact has also been felt on the interbank call money market, which represents overnight cost of funds for banks.

The call rate touched a high of 6.70 per cent on Wednesday, much higher than the repo rate and just shy of the MSF rate. The weighted average call rate, which is the operating target of monetary policy, settled at 6.65 per cent on Wednesday.

“With anticipation of moderation in pace of nominal growth, we expect a considerable gap between demand and supply of funds to the banking system. Further, a significant quantum of LTROs/TLTROs (Long-Term Repo Operations and Targeted Long-Term Repo Operations) are maturing in FY23 and FY24, which will put additional strain on liquidity,” economists from Bank of Baroda wrote.

“This can be corrected through conduct of RBI’s long term variable rate repo operations, with the frequency being increased,” they wrote.