The sharp rally in the government securities market since Tuesday due to the thaw in inflation suggests that a rate cut by the central bank in its June mid-quarter monetary policy review has been discounted, say market players.

With the headline inflation in April dipping to 4.89 per cent, the benchmark 10-year government security’s yield softened by 13 basis points in two days to 7.45 per cent even as its price jumped by 85 paise.

Yields and prices of government securities (G-Secs) are inversely co-related. A basis point is equal to one-hundredth of a percentage point.

The latest inflation reading, which compares favourably with the Reserve Bank of India's medium term comfort level of 5 per cent, has kindled hopes among market players that the central bank may cut the repo rate by 25 basis points at its upcoming review next month.

Further, RBI Governor Duvvuri Subbarao said on Tuesday that the fall in inflation would be taken into account for future policy decisions.

When inflation edges down, it creates the headroom for the central bank to cut interest rates to support growth. A cut in interest rates also lowers the cost of borrowing for the government and the economy.

Since the beginning of April, the G-Sec yields have plummeted by 50 bps. A rate cut next month could revive economic growth and increase credit demand in the banking system.

The RBI has already reduced repo rate by 25 bps to 7.25 per cent in its annual monetary policy review on May 3. However, bankers did not commit to any cut in the lending and deposit rates.

According to a public sector bank official, “To reduce lending rates, banks should be in a position to cut deposit rates, which we may not be able to do as the deposit growth remains sluggish. Till such time that the deposit growth remains low, liquidity is expected to remain tight.”

Market players are expecting the RBI to address the liquidity tightness in the banking system by buying government securities.

Banks’ average daily borrowings from the RBI under the liquidity adjustment facility to overcome short-term liquidity mismatches have been almost over Rs 1-lakh crore in the current month so far.

Bankers say they are not in a position to reduce lending rates because of liquidity tightness in the banking system, which is arising from government’s surplus balances with the RBI.

Mohan Shenoi, President – Global Treasury, Kotak Mahindra Bank, said: “Banks need to revive deposit growth, but small savings are already offering higher rates because of which banks cannot lower their deposit rates for now.”

> beena.parmar@thehindu.co.in