Mounting inflation levels has yet again forced the Reserve Bank of India to raise the Repo rate further by 50 basis points, taking the repo rate to 4.90 per cent. The central bank has hiked the repo rate for the second time in just a matter of 5 weeks.

Due to this change, the rate for the standing deposit facility (SDF) stands at 4.65 percent and the rate for the marginal standing facility (MSF) and bank rate is at 5.15 percent.

However, despite the anticipated rise in the repo rate, the mood in the bond markets remained calm as the Cash Reserve Ratio ( CRR) was left unchanged at 4.50%. As a rule, the bank must hold a certain percentage of deposits in cash in order to meet its liquidity requirements.

During the MPC's off-cycle meeting in May, the CRR was unexpectedly hiked by 50 basis points, aiming at withdrawing Rs 87,000 crore from the banking system. Therefore, bond market participants and economists had expected another hike this time aswell. Due to the fungibility of bonds, a reduction in liquidity impacts yields more than a hike in interest rates. Even though a 50% rate hike was largely priced in by the bond market, a CRR hike would have sucked out more liquidity in turn driving yields up sharply.

The benchmark 10-year yield and the shorter five-year bond yields dropped has dropped, while the three-year bond yields lost eight bps and two-year yields erased seven bps following the news. Bond prices and yields move in opposite directions.

Going forward, the bond market expects rate hikes to continue sharply as rising crude oil prices can put more pressure on inflation. The price of brent crude is $121 today, near its 14-year high.

The MPC has also unanimously agreed that it will focus on taking steps to ensure inflation remains within a comfortable range.

Despite the fact that real GDP growth for FY23 has been maintained at 7.2%, the inflation for the year has been raised to 6.7 %, with Q1 at 7.5 %; Q2 at 7.4%; Q3 at 6.2 % and Q4 at 5.8%. The MPC noted that inflation is likely to remain above the upper tolerance band of 6 per cent through the first three quarters of FY23.

Furthermore, RBI's signal that it will not accelerate liquidity withdrawal has also comforted the Bond market immensely.

As per experts, the bank liquidity improvement is structural, which should have a positive effect on short- and medium-term rates. Funds with a short to medium-term horizon should be a core component of a portfolio. There are also opportunities in long-duration assets due to the possibility of rate cuts and macro weakness in the near term. Bond investors should also consider dynamic bond funds if they wish to participate in long bonds.