Government bond yields rose to their highest in a year and near-end swap rates surged to their highest levels since the 2008 financial crisis on Wednesday after the Reserve Bank of India (RBI) further squeezed cash conditions as part of its defence of the beleaguered rupee.
The measures that came barely a week after similar tightening steps on July 15 sent a clear signal to bond markets that the RBI is willing to live with higher rates as it sees rupee stability as a priority.
The central bank also showed its resolve by accepting high cut-off yields at a treasury bill sale, with the 3-month bill yield being set at over 11 percent, the highest since at least 2007.
Although the rupee gained 1.1 percent on Wednesday, the failure to stabilise the currency is sparking expectations of stronger measures such as an outright hike in the cash reserve ratio or even a hike in the repo rate.
"In the near term, there is a very real risk of the overnight rate nudging close to 10.25 percent. The treasury bill sale shows the government has resigned to paying higher yields," said R. Sivakumar, head of fixed income at Axis Mutual Fund.
"The market is now looking at the measures at a rate signal. I would not rule out a repo or a cash reserve ratio hike at the July 30 policy."
The benchmark 10-year bond yield rose 25 basis points on the day to 8.42 percent. It had risen to a high of 8.50 percent, its highest since late May 2012. Volumes were at a paltry 105.70 billion rupees, the lowest so far in 2013.
The steps unveiled late on Tuesday capped individual banks' borrowing from the central bank at 0.5 percent of deposits and asked lenders to maintain their entire mandated cash reserve ratio on a daily basis as against 70 percent previously.
The government will also sell 60 billion rupees of cash management bills on Thursday to further soak up liquidity.
The OIS curve continued to flatten with the 1-year OIS rising sharply due to the cash tightening steps.
The near-zero spread between the 1-, 5-year rates before the central bank began tightening cash is now at a negative 104 bps.
The benchmark five-year OIS rate closed up 25 basis points to 8.43 percent. The one-year rate rose 58 bps to 9.47 percent. It surged to 9.50 percent in session, its highest since September 15, 2008.