MUMBAI (Reuters) - A shock move by the Indian government to withdraw over 80 percent of the country's currency in circulation has sparked a rally in bonds that could extend into late December as markets bet on a rate cut as soon as next month.
Since Prime Minister Narendra Modi announced the sudden removal of 500 and 1,000 rupee notes on Nov. 8 to crack down on corruption and forgeries, banks have been awash in liquidity as households rushed to tender their old bills - putting the brakes on a cash-reliant economy.
The near term hit to the economy has fed expectations of a rate cut in December, helping stoke the rally in Indian debt even as global bonds crumbled in the wake of Republican Donald Trump's upset U.S. presidential election win.
India's benchmark 10-year bond yields have dived 36 bps to 6.44 percent, a 7-1/2 year low, since Modi's banknotes announcement. That contrasted with the 10-year U.S. Treasury yield rising to an 11-1/2-month high of 2.339 percent on Friday on the view Trump's policies will prove reflationary and lead to faster-than-expected Federal Reserve rate increases.
"Earlier I was expecting a rate cut in February," said Ashish Vaidya, head of trading at DBS Bank in Mumbai.
"But now I expect a rate cut in December given that the demonetisation move is fiscal and inflation positive."
Short-term rates have also slumped, with bulk deposit rates down by as much as 42 basis points, reinforcing the view that the Reserve Bank of India may cut the repo rate in December, instead of earlier expectations for a cut in February or April.
The RBI, which has already lowered rates by 175 basis points since early last year, holds its next review on Dec. 7.
LESS CASH IN HAND
Modi's action on banknotes has seen banks receive more than $44 billion in deposits in the first four days - or one-third of the outstanding deposits in banking system, with a significant portion of this invested into bonds.
State-run banks bought around 231 billion rupees ($3.39 billion) of bonds since Nov. 8, including 174 billion rupees on Wednesday alone, according to clearing data.
Government bonds have also benefitted on hopes that inflation will ease as consumer demand is expected to slump in the near-term as people hold off on purchases.
Inflation already eased to 4.20 percent in October, undershooting the RBI's 5 percent target by March. The lower inflation impulse from the banknotes move has analysts wagering on the RBI cutting rates by 50 bps by early 2017, compared to previous calls for 25 bps.
"In the very short term the move to remove the larger denomination currency will mean that the cash economy gets impacted which will slow down demand in the economy," said Anindya Dasgupta, head of local market trading at Barclays.
"So to that extent this will have a deflationary impact as well as hit growth and that can bring forward the timing of any rate cut or rate cuts."
($1 = 68.1179 rupees)
(Editing by Shri Navaratnam)