The action, which had shifted from equity markets to forex market after the US Fed statements, is now hotting up in the bond market.
This is because of the utter confusion among the traders after the Reserve Bank of India's steps to curb liquidity. The central bank had raised the short-term lending rates at its emergency funding facility window for banks and also restricted funds lent to them through liquidity adjustment facility (LAF).
The lending rate at the LAF is called the repo rate, which is the central bank's policy rate and now at 7.25 percent. The rate at the emergency finding window, called the marginal standing facility (MSF), has been increased to 10.25 percent.
The effect of the twin moves of restricting funding through the LAF and increasing MSF rate signalled an increase in rates as they squeeze the supply of cash in the banking system.
One more step that the RBI announced was a sale of bonds through open market operation. The move was aimed at sucking out excess cash from the system. The bank was planning to draw Rs 12,000 crore out.
The problem with this step is that it is a sale of bonds. Banks can easily decide not to buy. As the proverb goes, one can only take a horse to the water, but cannot make it drink.
So, what happened was banks quoted higher yields (or returns) at the bond sale auction, forcing the RBI to reject most of the bids. The higher the yields, the lower the price. So The central bank ended up drawing out just Rs 2,532 crore from the system, as against its target of Rs 12,000 crore. In simple terms, an utter failure.
The development assumes significance because earlier some of the state governments had also failed in their attempt to raise funds. The reason was the same. Traders quoted higher yields.
The RBI's own T-bill auction-to raise short-term funds by selling with bonds having 91 day and 182 day maturities-also had flopped for the same reason.
The RBI's rejection of bids quoting higher yields at these auctions is conflicting with its own action, which signalled an upmove in the interest rates in the system.
"You raised the borrowing costs, but you do not want to accept bids at higher yield... what is that you want,'' a trader has been quoted as saying in an analysis in the Economic Times today.
The drastic rise in the bonds yields-from 7.5 percent on Monday to 8.13 percent on Tuesday-after the RBI's steps have resulted in huge losses for traders. Mutual funds alone could have lost around Rs 6,000 crore, says an analysis in the Economic Times today.
Meanwhile, the gain from the step has been only just a 0.4 percent pull back in the rupee.
So the RBI may be forced to take more steps if it wants to support the rupee further. However, indications are that there is no chance of a rate hike now, especially since the growth and demand in the economy are at low levels.
Earlier Finance Minister P Chidambaram and today Prime Minister Manmohan Singh assured that the RBI steps are not long term in nature and should not be perceived as a prelude to hiking policy rates.
Another tool to control the rupee liquidityin the RBI kit and which it could use now is cash reserve ratio (CRR) of banks. CRR is the proportion of deposits banks need to keep with the RBI for which they do not get any returns. This is at present at 4 percent.
Even a 0.25 percentage point increase in this ratio will drain out a substantial amount of rupee liquidity from the system.
A few economists now feel that this may be one tool that the RBI is looking at.
"A CRR hike is quite plausible though that may be an extreme step," Madan Sabnavis, chief economist, Care Ratings, has been quoted as saying in another report in the Economic Times today.
According to him, if the RBI thinks that the higher rupee liquidity is indeed increasing speculative trades in the rupee, adding to the forex volatility, it may increase CRR.
Today's bond auction could be one of the determining factors for the RBI, says the report. If again banks seek higher returns, the central bank may be forced to reject the bids.
Already, primary dealers, who buy the bonds if the RBI doesn't find enough takers at the auction, have increased their fee for underwriting.
According to a Times of India report, to buy 10-year benchmark bond being auctioned today, the fee is up to 80 paise per Rs 100 worth of bonds. The fee for some the other bonds being auctioned today have witnessed 100-fold increase, the report said.
All these are indications of rising borrowing costs.
As of now, traders are keeping their fingers crossed as they are closely watching today's bond auction. Its outcome will provide cues as to what may be playing on the RBI's mind.