Liquidity Anchors CP, CD Yields, but Grip Weakens; Ball in RBI’s Court

India’s money market has had a simple trade for much of the past couple of months: follow the liquidity. Cash flooded the banking system, and certificate of deposit and commercial paper yields fell with it.

That trade may now be running out of road, but not by far. Three-month CD yields are around 5.93%, down 132 bps since June 5. Market participants see them moving towards 6.00%-6.25% over the next couple of months as tax outflows, credit demand and RBI liquidity absorption begin to bite. The adjustment is expected to be modest because the banking system still has enough surplus cash to cushion much of the pressure from changing rate expectations and higher crude oil prices.

“The outlook is how fast RBI is able to pull out this money. That is the entire question,” said Pratik Shroff, Fund Manager–Fixed Income at LIC Mutual Fund. Shroff expects tax outflows and potential bank credit demand to push three-month CD rates higher, but sees the near-term move contained within 6.00%-6.25%.

Sheetal Kapadia, Director at money-market broking firm Crest Finserv, also sees little room for a large move either way. “The major rally has already happened,” she said. That is increasingly the story of the front end.

Rally Losing Steam?

Three-month CP deals this week ranged from 5.94% to 6.82%, depending on credit quality, with the FBIL benchmark around 6.20%. Primary issuance on September 8-9 showed how wide the credit spread remains. Power Finance Corporation raised three-month money at 5.94%, Bharat Petroleum paid 5.95% and Reliance Industries priced at 6.0065%. Bajaj Securities paid 6.82%, while L&T Finance issued one-year paper at 7.455%.

Corporates have a clear incentive to issue because funding is substantially cheaper than it was three months ago. Banks have less reason to issue CDs after FCNR(B) inflows boosted deposits and liquidity. Mutual funds, meanwhile, still have money to deploy. That combination has helped CP issuance return while keeping CD supply relatively scarce, and may also put a floor under yields as cheaper funding attracts more borrowers.

The bigger story is how much of the repricing has already happened.

Source: Analysis of CCIL-FTRAC data

The liquidity shock has been concentrated at the shortest end. Three-month CD yields have fallen 132 bps since June 5, compared with just 33 bps at one year. The premium on one-year CDs over three-month paper has consequently widened to 133 bps from 34 bps.

That is a steep curve for a market still sitting on surplus cash. It also explains why participants see limited room for another large front-end rally.

Liquidity Matters Most

The relationship becomes clearer in the data. An analysis shows that three- and six-month CD rates have moved closely with changes in banking-system liquidity, while that relationship largely disappears further out.

For CDs, liquidity explains much more at three and six months than it does at nine months or one year. CP remains more closely linked to liquidity across the curve. Beyond six months, CD pricing appears to reflect limited bank issuance, investor duration preferences and expectations about where policy rates may eventually settle.

The CP-CD spread tells the same story. CDs yield 1 bp more than CP at nine months and 6 bps more at one year, while at three months they still yield 27 bps less. The segment that gained most from the liquidity wave may therefore have the least room left to rally.

The RBI Play

The next move depends on the RBI. FCNR(B) inflows dramatically altered the liquidity picture, and the issue now is how quickly that surplus is withdrawn.

ANZ Research estimates banking-system liquidity at ₹10.5 trillion-₹11 trillion, or about 3.7% of net demand and time liabilities, following larger-than-expected foreign-currency inflows. Even after currency leakage and maturing foreign-exchange forwards, ANZ expects liquidity to remain near ₹9 trillion, or 3.1% of NDTL, by December.

It expects the RBI to absorb about ₹4.5 trillion through variable rate reverse repo operations, leaving a similar amount to be managed through other instruments. Market participants are therefore watching for stronger liquidity-absorption measures, including sell/buy swaps or an incremental cash reserve ratio.

A quicker RBI drain would push short-term yields higher. Stronger bank credit demand and tax outflows could add temporary pressure. A slower withdrawal would leave the front end pinned for longer.

ANZ expects the first repo-rate increase only in December. If that view holds, the liquidity cushion may be removed gradually rather than abruptly. For now, that argues against both a sharp sell-off and another large rally.

Three-month CDs are already near 5.9%. A 6.00%-6.25% range increasingly looks like the zone where liquidity support meets policy uncertainty.

For investors, the trade may become less about chasing another fall in yields and more about rolling short-term paper while waiting for the RBI. For issuers, the window remains attractive because borrowing costs are still far below where they stood in June.

The FCNR(B) liquidity wave has already done its work. The next repricing will depend on how quickly the RBI takes that money back.