Inflation woes nix chances of India yield curve steepening -traders

MUMBAI (Reuters) - The expectations of India's bond yield curve steepening in the second half of the year are fading as the recent jump in oil prices re-ignites inflation worries and prevents shorter-dated yields from falling despite lower supply, traders said.

The government bond yield curve has remained flat for the past few weeks, with the four- and five-year yields at around 7.25% and the 10-year benchmark bond yield at 7.23%.

Typically, a yield curve slopes upwards as investors expect more compensation for taking on the risk that rising inflation will lower the expected return from owning longer-dated bonds. That means a 10-year note typically yields more than a two-year one as it has a longer duration.

A flat curve, on the other hand, reflects uncertainty over the monetary policy outlook and liquidity conditions.

"Earlier, there were expectations the curve may start steepening from the second half," said VRC Reddy, treasury head at Karur Vysya Bank.

"But (recent news of Indian bonds') index inclusion will favour the long end, while the spike in oil prices has raised fresh inflation concerns, which will weigh on the short end."

"We do not expect any change in the pattern of the yield curve as bonds are driven by U.S. Treasuries for the time being," said Vijay Sharma, senior executive vice president at PNB Gilts.

The 10-year U.S. Treasury yield is hovering close to its 16-year high of 4.70%.

Meanwhile, benchmark Brent crude prices rose for the fourth straight month in September, rekindling inflation worries and the chances of interest rates staying elevated.

"We expect the yield curve to continue to remain flat for some time as the higher-for-longer (rates) theme prevails," said Anshul Chandak, head of treasury at RBL Bank.

Moreover, likely tight liquidity may put a floor on shorter-dated yields despite lower supply, traders said.

India is due to borrow 6.55 trillion rupees ($78.73 billion) from October to March, of which less than 17% will be through three- and five-year papers, while 10-year bonds will account for over 22%.

Still, traders ruled out a yield curve inversion as the low odds of a rate hike any time soon effectively rule out a selloff in short-end papers.

"An inversion may not happen," said Jayesh Mehta, India country treasurer, Bank of America.

"But the flattening will continue for some time." ($1 = 83.1950 Indian rupees)

(Reporting by Dharamraj Dhutia and Siddhi Nayak; Editing by Swati Bhat and Savio D'Souza)

By Dharamraj Dhutia and Siddhi Nayak