Bonds rallied on Friday with the yield on the 10-year benchmark bond falling sharply after the Reserve Bank of India (RBI) left policy rates unchanged and signalled a reversal in the monetary tightening cycle.

The central?s bank?s assurance, that it would step in to ease liquidity if needed through bond buybacks, or open market operations (OMO) pepped up the sentiment, sending the benchmark yield down by more than 10 basis points to a low of 8.37% from 8.49% a day earlier.

Ananth Narayan G, treasury head, Standard Chartered Bank, said: ?We expect OMOs in the near future which will support bond prices.? Added Prathasarathi Mukherjee, president, treasury, Axis Bank: ?The market has got a degree of comfort by the pause in the rate-tightening cycle and also the assurance of more OMOs.?

Benchmark bond yields on Friday dropped to their lowest levels since September 28, 2011, a day before the government announced R53,000 crore of additional borrowing for the second half of 2011-12. The yields on the 10-year bond had shot up as much as 60 basis points to 8.97% in November following the announcement.

However, liquidity-boosting measures, such as OMOs, an increase in the ceiling on FII investments in gilts and corporate bonds and a pause in the rate tightening cycle, have seen the benchmark bond yield come off close to 60 basis points from its peak.

Most treasurers believe that the worst is behind for the bond markets and the only spoilsport could be another round of borrowing by the government, which is more than what the market expects. Most economists expect the fiscal deficit target could slip from 4.6% to 5.4%-5.6% kind of levels. According to experts,

a 1% increase in the fiscal deficit translates into an additional borrowing of R1 lakh crore. ?The worst could be over for the bond market, at least in the short term. The market already has built in expectation of additional borrowing being announced,? said Mukherjee.

?There could be another R50,000-60,000 crore of additional borrowing being announced. But the market is well prepared for it and there will also be OMOs to support that kind of borrowing. However, if there is larger-than-expected borrowing or if OMOs disappoint, the market could react negatively,? said Ananth Narayan.

Banks on Friday borrowed R1,16,690 crore from the central bank’s daily liquidity adjustment facility (LAF). The average borrowing through the daily LAF has increased to R90,000 crore during the November-December period from R49,000 crore during April-October. The liquidity deficit in the banking system has shot up close to 2% of NTDL (net time and demand liabilities), way above the central bank’s desired 1% level.

Taking a note of this situation, the central bank in its mid-quarter monetary policy review stated: ?There are currently no significant signs of stress in the money market. The overnight call money rate is stable around the policy repo rate and liquidity facilities such as marginal standing facility (MSF) remain unutilised. However, in view of the fact that borrowings from the LAF are persistently above the Reserve Bank’s comfort zone, further OMOs will be conducted as and when seen to be appropriate. ?

?There isn?t much strain on the system as banks can borrow from LAF using their excess SLR. However, that fact that the deficit is about 2% of the NTDL is not a good sign,? said Standard Chartered?s Narayan.