By Subhadip Sircar and Pratigya Vajpayee

Caught off-guard by India’s decision to close early a special window to draw foreign-currency deposits, traders are now paring bets on gains in the rupee and short-term bonds.

Citigroup Inc. sees the local currency’s gains capped at 95 per dollar in the near-term, compared with 94 earlier. It also lowered its estimate for inflows under the facility by $10 billion to $70 billion. Industrial and Commercial Bank of China Ltd. said a popular yield curve steepening trade — where the gap between the shorter and longer bonds widen — has “less runway” now. 

The estimates are being reworked after the central bank Friday decided to end a program attracting dollars from overseas Indians a month earlier than planned, having garnered more than $50 billion. Lower inflows may remove support for markets at a time when the RBI has been stepping in to bolster the rupee. Upward pressure on short-term yields risks raising near-term funding costs for banks and companies.

The move surprised traders as Reserve Bank of India Governor Sanjay Malhotra had ruled out a premature closing of the program earlier this month. Goldman Sachs Group Inc took profit on its short baht-rupee recommendation, expecting the Indian currency to trade range-bound moving forward. 

The impact was visible across the market on Monday, with the rupee weakening the most in nearly a month to underperform Asian peers, while yields on the five-year debt recorded their biggest rise in over a month.

The FX deposit flows “were being deployed heavily into four- to five-year government bonds, softening short-end yields, while the 10-year stayed comparatively stable as banks limited duration risk,” said Alok Sharma, treasury head at ICBC in Mumbai. “The market had expected the spread to widen further into September, but that steepening impulse now stops.”

The steepener trade became popular after the RBI in early June announced the plan, which involved the central bank swapping the dollars the banks garnered for rupee. That cash was deployed primarily in shorter-tenor assets, with the spread between the five-year bond and 30-year widening to over 100 basis points this month.

The deposit facility helped the central bank’s forex reserves swell to $707 billion, near their record high of $728 billion, giving the RBI more firepower to intervene in support of the rupee.

“Given a sizeable chunk of these mobilized dollars have been used for intervention, the accretion to the FX reserves will likely fall short of expectations,” said Nitin Agarwal, head of India trading at Australia and New Zealand Banking Group. “The pressure on FDI and foreign portfolio flows becomes more immediate to build extra cushion for these deposits as they become due in three years.”

Still, the rush to raise these deposits before the window closes may help boost banking cash this month. ITI Mutual Fund expects liquidity surplus to peak around 4.5 trillion rupees ($47 billion) in September, from 3.6 trillion rupees as of Aug. 16.

“The liquidity surplus is expected to remain quite high through September,” said Upasna Bhardwaj, chief economist at Kotak Mahindra Bank. “In the near term, we will continue to monitor the extent of FX intervention which could drain part of the liquidity surplus.”