RBI turns back to Operation Twist, rejects OMO bids!

RBI turns back to Operation Twist, rejects OMO bids!

Last updated: 25 Sep, 2020 | 03:10 pm

RBI turns back to Operation Twist, rejects OMO bids!

RBI continues to check upward pressure on yields. 

  • The Reserve Bank of India (RBI) rejected all bids it received for its Open market bond purchase auction on Thursday. This was the first outright bond purchase program of this fiscal year.
  • RBI received bids to the amount of ₹66,473 crores for long term bonds against the planned ₹10,000 crores.
  • RBI’s rejection shows the central bank’s unwillingness to give the investors high yields as demanded by them. 
  • Notably, there has been a huge oversupply in the government bond market causing upward pressures on yields. RBI has time and again shown its determination to keep yields under control so that the borrowing cost for the government is not increased.
  • “RBI has again resorted to Operation twist to manage yields, as pointed out by INDmoney in its previous analysis. We reiterate that the trend is likely to continue further.” RBI announced that it will conduct a fresh leg of operation on October 1, where it will buy long term bonds worth ₹10,000 crores and sell an equivalent amount of shorter-term papers.

What are Open Market Operations?

  • Open market operations refer to the sale and purchase of government securities and treasury bills by RBI or the central bank of the country. 
  • The objective of OMO is to regulate the money supply in the economy. When the RBI wants to increase the money supply in the economy, it purchases the government securities from the market and it sells government securities to suck out liquidity from the system.

How are Open Market Operations used in Operation Twist?

  • From December 2019  onwards, RBI has been conducting OMOs in which it is simultaneously selling short-term securities and buying long-term securities. 
  • Here, the objective of OMO has been to manage the yield curve (reduce the difference in short term and long term rates) rather than managing liquidity. 
  • By purchasing long term bonds, the RBI increases the demand for these and thus pushing up the prices which leads to a fall in yields and by selling short term securities, their prices fall, consequently raising their yields. 
  • This helps to flatten the curve by reducing the spread between long term and short term yields.
  • “This simultaneous selling of short term securities and buying of long term securities is known as ‘Operation Twist’. It was first used by the US Federal Reserve in 1961 and then in the year 2011.”

What is the RBI trying to do? 

  • For the past few months, RBI has been extensively using Operation twist instead of direct OMO purchases to avoid adding more liquidity to the system which is already flush with liquidity after heavy liquidity pumping across Central Banks around the world.
  •  Inflation has been on a rise lately and is expected to shoot up over the next 2-3 years, thus limiting the RBI’s scope for further rate cuts, with less flexibility to use the interest rate mechanism RBI had to shift its focus on OMOs.
  • Flattening of the yield curve:  Recent rate cuts have reduced the short term yields thus steepening the curve, a steep yield curve is not a good sign for the economy. The following chart shows how India’s yield curve has steepened over the last year.
  • Induce long term borrowing: The RBI is suffering from the problem of transmission, Despite the moves by RBI, banks have not been extending credit to the cash strapped economy. Bank credit (non-food) is down ₹1.6 Lk Cr in this Financial year alone. This includes loans, cash credits (against pledged assets) and overdrafts extended to companies. 
  • This is because of the heightened credit risk in lending currently caused by a widespread disruption in the economy. Banks have preferred to park their money in safer Government securities instead- investments by banks in government securities is up over ₹4 Lk Cr this FY (Since Apr 1). 
  • RBI is trying to make lending easier via OMOs.Long-term Government bond yields act as an interest-rate benchmark for auto loans, home loans, or for that matter any long-term investments or borrowing. 
  • So, by bringing down long-term bond yields, loans will become cheaper. With long-term bond yields coming down, not only the government would be able to borrow money at a cheaper rate from the market, but the corporate sector would also benefit as yields of corporate bonds would follow suit. 

India’s 10Y G-sec yield rose sharply to 6.22% at the end of August because of high inflation expectations. However, after RBI’s special leg of Operation Twist on 27th August and 3rd September, the yields cooled off a bit.

INDmoney Analysis 

  • The RBI remains constrained in its possible actions as rate cuts are having low impact on stimulating the economy while risk on impact to our currency remains high (lower interest rates lead to outflows from the country). 
  • Shooting fiscal deficit and increased market borrowing coupled with high inflation expectations will put upward pressure on the bond yields thus making the RBI’s job tough.
  • Monetary policy changes and fiscal measures are good measures to promote growth in the short term. However, in the long term, fundamental factors of the economy guide real growth and sustainability.
  • We expect the interest rates to increase and yield spread to decrease in the next 2-3 years.
  • In an increasing interest rate environment, high duration funds, and long-maturity bonds tend to underperform compared to low duration funds and bonds.
  • Stick to AAA-rated low duration funds and bonds over high duration funds, and long-maturity bonds as yields will remain volatile in the near future but in the medium term (2-3 years) the rate cycle is expected to bottom out and move up.