India failed to sell treasury bills at a weekly auction after the central bank tightened policy for the first time since 2011, driving up interbank funding costs by the most in more than a year. The Reserve Bank of India, which held the sale, rejected bids worth 293 billion rupees ($4.9 billion) received for a combined 120 billion rupees of 91- and 182-day notes offered, it said in an e-mailed statement. The overnight interbank borrowing rate in Mumbai surged 170 basis points to 8 percent today after the RBI increased on July 15 two of its interest rates by 2 percentage points each, while keeping the benchmark repurchase rate unchanged, to arrest a slide in the rupee.

The failure of the bill sale follows an offering of bonds yesterday by state governments, where the borrowers met only 26 percent of an 86 billion rupee target. With this week's rate increases, RBI Governor Duvvuri Subbarao joins policy makers from Brazil to China in reining in money-market liquidity to stem currency losses and ensure stability in the financial system. The rupee has lost 8.7 percent since March 31 in Asia's worst performance.

“Short-term rates are at an elevated level, so bids may have been at higher yields than what the government was comfortable with,” said N.S. Venkatesh, the Mumbai-based head of treasury at IDBI Bank Ltd. “The market moves have been a knee-jerk reaction to the RBI's steps, and I think within a week or so things should settle down, when the market would have a clearer perspective of how liquidity will be.” India last sold 91-day bills at 7.48 percent on July 10 and 182-day notes at 7.60 percent on July 3.

Eoin Treacy's view Over the last two days India's moves to tighten liquidity have resulted in a sharply inverted yield curve. At the close of business today 10-year yields had risen to 8.045% while 2-year yields had risen to 8.5%. The heightened volatility of the government bond markets highlights just how aggressive the RBI has been in its attempts to tackle what might be described as over exuberance in the banking sector as well as the stability of the currency.

This was also evident in the reaction of bank shares with the Bombay Banks Index pulling back sharply to test the April lows. A countermanding upward dynamic is now required to question potential for additional weakness.

The performance of the bank sector is particularly noteworthy because it has been such a bellwether for the wider market since at least 2008. The Bombay Banks/BSE500 ratio has held a progression of higher major reaction lows since 2008 but has been deteriorating since hitting a new peak in May. It is now challenging the medium-term uptrend and will need to find support soon if the banking sector is to retain its leadership role. A sustained break in the ratio's uptrend would be a discouraging signal for the wider market.

While the NIFTY Index closed in positive territory today, it will need to hold above the 200-day MA if the medium-term upside is to continue to be given the benefit of the doubt.