Bond yields and rupee to closely track RBI's monetary policy meet

Indian government bond yields and the local currency will track the Reserve Bank of India's monetary policy decision, due mid-week, for guidance, and any dovish tilt in tone could see the benchmark bond yield break below the crucial 7.25% level.

The RBI is widely expected to raise interest rates by 25 basis points (bps) on Wednesday, which many traders believe will be the last before a prolonged pause. Some also expect the central bank to shift to a neutral policy stance.

The RBI has raised the repo rate by 225 bps so far this financial year while maintaining a "withdrawal of accommodation" stance.

"Currently, the market expectation is that there could be one more rate hike ... following which there could be a long pause," said Ashish Parthasarthy, treasurer at HDFC Bank.

"If expectations around a rate cut (later in the year) start getting baked in, we could see more demand for duration papers."

India's benchmark bond yield ended at 7.2776% on Friday, having dipped 11 bps last week to post its biggest slide since the week ended Nov. 11 and nearly erasing the nine bps increase in the previous two weeks.

Market participants expect the benchmark bond yield to be in the 7.20%-7.35% band this week.

Investor sentiment got a boost last week after the central government, in the federal budget, announced gross borrowings of 15.43 trillion rupees ($188.41 billion) for next fiscal, lower than market estimates of 16 trillion rupees.

Besides the RBI policy decision, traders will also focus on the second tranche of green bond issuance, due on Thursday.

In its first-ever such issuance, the government raised 40 billion rupees each through five- and 10-year bonds at cutoff yields that were 5-6 bps lower than prevailing yields.

Meanwhile, the rupee ended about 0.4% lower at 81.8275 per U.S. dollar last week, having mostly traded on the weaker side of 82 despite the greenback's fall after the U.S. Federal Reserve's dovish tilt in its policy meeting.

The Adani Group-led selloff in the equity markets has weighed on the rupee and will set the tone this week as well, traders said. Foreign institutional investors withdrew around $1.5 billion from the stock market last week alone.

"Unless there are serious amounts of foreign portfolio outflows, I don't expect the rupee to depreciate sharply this week," said Ritesh Agarwal, head of treasury at CTBC Bank.

He expects to currency to trade between 81.70-82.30.

The markets are expecting a terminal rate of 6.50%-6.75% anyway and even if the RBI chooses not to signal about future hikes, this event should not be rupee negative either, he added.

U.S. non-farm payrolls data released on Friday will give the initial impetus.