Festival-season cash demand is putting more money in people's pockets, and threatening to leave banks with a shrinking liquidity cushion, potentially keeping short-term borrowing rates elevated even as longer-term government bonds rally on favourable overseas cues. Currency in circulation has already increased by 1.8 trillion rupees so far this financial year to 43.5 trillion rupees, compared with an increase of 900 billion rupees during the corresponding period last year, according to Kotak Mahindra Bank.

The increase in currency in circulation reflects cash moving out of the banking system and into the hands of the public, reducing funds available to banks. Continued seasonal withdrawals, alongside the Reserve Bank of India's foreign exchange intervention, could erode the liquidity surplus and put renewed upward pressure on overnight borrowing rates, commercial paper, certificates of deposit and Treasury bill yields.

"We estimate durable liquidity surplus to moderate further to around 5.5 trillion rupees at the end of the running fortnight, driven by continued direct FX intervention and festive season-led high CIC leakage," said Harsh Doshi, economist at Kotak Mahindra Bank, in a research note. 

Durable liquidity surplus was estimated at 6.5-7.0 trillion rupees at the end of October, down from 10.1 trillion rupees at the end of September.

Banking system liquidity stood at a surplus of 1.93 trillion rupees on Wednesday, according to RBI data, compared with around 304 billion rupees on October 27. However, the surplus is expected to moderate to around 1 trillion rupees by November 15. The recent improvement could prove temporary also because of excise duty and tax deducted at source payments expected to drain funds next week, followed by GST-related outflows in the second half of November.

Government bond redemptions worth around 667 billion rupees during the month could provide some relief. The government is scheduled to redeem 395 billion rupees of the 5.74%, 2026 bond on November 15, and 272 billion rupees of the 8.15%, 2026 bond on November 24.

However, the liquidity injected through these repayments could be partly offset by tax collections, festive cash withdrawals and continued RBI intervention in the foreign exchange market.

The sensitivity of short-term rates to liquidity conditions was evident in the money market.

The improvement in liquidity helped ease overnight borrowing costs earlier in the month. The weighted average call rate declined to 5.45% on November 3 from 5.75% on October 27.

However, overnight rates have begun firming again. The weighted average call rate rose to 5.51% on Wednesday and was at 5.69% around 1335 IST on Thursday. The weighted average rate in the triparty repo market also increased to 5.59% in Thursday's intraday trade from 5.54% on Wednesday.

Overall, the movement suggests that even a sizable aggregate liquidity surplus may not prevent temporary pressure on overnight borrowing costs. A further decline in surplus funds could push rates higher within the RBI's liquidity adjustment corridor, particularly around tax payment dates.

The cut-off yields, which had declined by 4 basis points at Wednesday's auction compared with the previous week, are expected to edge up again as liquidity tightens.

The pressure could also extend to certificates of deposit and commercial papers as banks and companies compete for short-term funds.

In secondary-market transactions on Wednesday, HDFC Bank certificates of deposit maturing on January 22 traded at a yield of 7.60%, while those maturing on February 24 were dealt at 7.69%. Kotak Mahindra Bank CDs maturing on January 8 traded around 7.45–7.48%.

In the commercial paper market, Bajaj Finance paper maturing on November 26 traded at 7.35%, while Sundaram Finance paper maturing on January 28 was dealt at 7.93%. Motilal Oswal Financial Services paper maturing on the same date traded at 8.45%.

Although issuer-specific credit risks and maturity differences influence pricing, a smaller liquidity surplus could keep funding costs elevated, particularly for borrowers seeking funds beyond the next monetary policy meeting.

Expectations of a 25-basis-point repo rate hike in December are likely to limit sustained easing in short-term yields. "Short-term government bond yields are expected to inch up slightly as the December rate hike is likely to materialise. Although banking system liquidity is around 2 trillion rupees, the surplus is expected to be drained towards the end of the month," said Radhika Piplani of Motilal Oswal Financial Services.

The pressure could extend to government bonds maturing in one to five years, which remain sensitive to expectations of further RBI tightening.

In contrast, longer-term government bonds have benefited from the sharp decline in crude oil prices and softer US Treasury yields, which have eased concerns over imported inflation and the extent of further monetary tightening.

The divergence suggests that while longer-term gilts could continue to benefit from favourable global developments, short-term rates will depend more directly on domestic liquidity conditions and the expected path of the policy repo rate.

For now, the banking system remains in surplus, but the combination of festive cash demand, approaching tax outflows and continued RBI foreign exchange intervention could make the recent liquidity relief short-lived, leaving short-term money market rates struggling to participate in the broader bond rally.