Indian government bonds gave up most early gains on Thursday as stronger-than-expected dollar inflows from a central bank scheme were offset by a fresh spike in oil prices.
The benchmark 6.94% 2036 bond yield settled at 6.9646%, versus 6.9754% on Wednesday, after falling to 6.9323% intraday. Bond yields move inversely to prices.
Shorter maturities outperformed, with the five-year yield falling 4 basis points to 6.5216%.
Traders covered short positions earlier in the session, snapping a five-day selloff, after India drew a larger-than-expected $136.38 billion under the central bank's dollar-attracting schemes between June 5 and August 31.
The inflows pushed the banking-system liquidity surplus to a record 9.7 trillion rupees and lifted the rupee 0.5% to 94.4850 per dollar.
Analysts said the dollar boost would strengthen the Reserve Bank of India's ability to support the rupee and could push the balance of payments into surplus.
"Market focus has now shifted to the consequences of these inflows for RBI's liquidity stance and operations," ICICI Securities Primary Dealership said, estimating that system liquidity could peak above 10 trillion rupees before easing to 8-8.5 trillion rupees by month-end.
The RBI has conducted 28 variable-rate reverse repo operations since August 5 to drain excess cash, but traders expect more stringent measures.
The Primary Dealership said the central bank may need to raise the cash reserve ratio by 100 basis points and sell 2 trillion rupees of short-dated bonds through open-market operations.
Separately, a renewed oil-price surge capped the rally.
Brent crude climbed above $97 a barrel due to the escalating U.S.-Iran conflict, stoking concerns over India's inflation outlook and fiscal position.
RATES
Overnight indexed swap rates fell, aided by abundant liquidity and softer U.S. Treasury yields.
The U.S. 10-year yield eased from a three-year high of 4.81% to 4.7720%.
The one-, two- and five-year OIS rates ended 1.5-4.5 bps lower at 5.9950%, 6.19% and 6.4875%, respectively.
