RBI's liquidity measures drive short-term bond rally, widening yield spread

The yield spread between the three-year government bond and benchmark 10-year bond has increased by more than three times to 48 basis points, against 15 bps at the start of FY26

The yield spread between the three-year government bond and benchmark 10-year bond has increased by more than three times to 48 basis points, against 15 bps at the start of the financial year (FY26). A combination of monetary policy easing, abundant liquidity infusion in the system, and a 100-bp cut in the cash reserve ratio (CRR) by the Reserve Bank of India (RBI) in its most recent monetary policy review weighed on the bond yields, particularly on short-duration bonds.

 

“Post rate cuts and liquidity infusion by the RBI, short term rates have fallen more than long term yields,” said a dealer at a state-owned bank. “The liquidity started improving from the last few days of March and then rate cut in April, which led to the steepening of the yield curve,” he added.

 

The yield spread between the two bonds has widened by 12 times in the current calendar year (2025). At the start of the calendar year, the yield spread stood at 4 bps. One basis point is a hundredth of a percentage point.

 

The yield on three-year government bonds settled at 5.83 per cent on Thursday, whereas that on benchmark 10-year bonds settled at 6.31 per cent.

 

“The yield curve was almost flat at the start of the year, the demand started pouring in the short term after the RBI’s Open Market Operations (OMOs), Variable rate repo (VRR) auctions and swaps,” said a dealer at a primary dealership.

 

Since January, the RBI has injected Rs 9.5 trillion of durable liquidity into the banking system. This infusion helped shift liquidity conditions from a sustained deficit since mid-December to a surplus by the end of March.

 

The transition was reflected in the muted demand for daily VRR auctions, and elevated standing deposit facility (SDF) balances, which averaged Rs 2 trillion during April–May. Of the total liquidity injection, Rs 5.2 trillion came through open market purchases (including secondary market purchases), while long term VRR auctions and USD/INR buy-sell swaps added Rs 2.1 trillion and Rs 2.2 trillion, respectively.

 

The domestic rate setting panel cut the CRR by 100 bps to 3 per cent in four tranches starting September. The reduction in CRR is expected to infuse Rs 2.5 trillion of primary liquidity in the banking system by the end of November.