Traders see liquidity tightening in India to drive bond playbook in 2021

India’s sovereign bond investors are converging on a trade idea for 2021. They’re betting that short-term yields would rebound as the central bank soaks up excess cash on signs of an economic recovery.

RBL Bank Ltd. and Quantum Asset Management Ltd. are among those forecasting that liquidity tightening by the Reserve Bank of India will lead short-end rates to rise faster than the long-end -- bear-flattening the yield curve.

“Short-end rates, of up to three years maturity, are currently priced aggressively due to excess liquidity and thus carry maximum risk of a reversal,” said Pankaj Pathak, fixed-income fund manager at Quantum Asset Management Ltd. in Mumbai. “The longer segment may continue to get RBI’s support from open market operation purchases and operation twists.”

There’s growing consensus among traders that the RBI will have to start draining excess cash from the banking system, as abundant liquidity crashed short-term rates and threatened to stoke inflation. Nomura Inc. expects the central bank to start doing so as early as the second quarter of 2021.

The spread between the 10-year yield and the secured overnight rates may gradually narrow, according to Suyash Choudhary, head of fixed income at IDFC Asset Management Ltd. However, it may stay higher than the average seen in the past few years with with monetary policy remaining accommodative and bond supply staying high, he said.

Even as the RBI expects the nation to exit a recession in current quarter, economic risks remain as India is still the second-most affected nation by the coronavirus after the U.S.

“Liquidity won’t be taken back in a hurry,” Anand Bagri, head of domestic trading at RBL Bank Ltd. said in a recent interview. “Once liquidity withdrawal starts, we may see short-end rates moving up by 40-45 basis points with a bear flattening bias.”