Not so long ago, bond dealers were considered to be god's gift to the Indian financial system. With bond yields going down and prices going up, they were making money with both hands and pocketing hefty bonuses.

The yield on the 10-year benchmark government paper, which was just above 6 per cent in January 2003, rose to 6.75 per cent in February but thereafter it started moving southwards.

The yield dipped to as low as 4.97 per cent in October 2003. From that level, the 10-year government bond yield has now gone up to its four-year high of 7.92 per cent, a level last seen in May 2002. It could be a matter of a few days before it touches 8 per cent.

A fear psychosis has gripped the bond market and, given a choice, bond traders would like to go underground as with falling prices every day (and rising yields), they are losing money.

The rise in interest rates has spoilt their party. But more than the rate hike, they are blaming the Reserve Bank of India [Get Quote] for the plight of the bond market. What has the banking regulator done?

Unlike in the past, it has chosen to surprise the market again and again. First, on April 19, when it announced its monetary policy, the RBI chose to ignore all global cues and domestic developments and against widespread expectations of a rate hike, it favoured the status quo.

Then, on June 8, six weeks ahead of its quarterly monetary policy, the RBI again surprised the market. This time by hiking the reverse repo and repo rates by 25 basis points each (one basis point is one hundredth of a percentage point) within hours of the European Central Bank raising its rates.

Yet another surprise was in store for the bond market last week. The RBI announced a Rs 9,000 crore (Rs 90 billion) auction of dated securities, to be held on June 22, instead of the scheduled Rs 5,000 crore (Rs 50 billion)? By raising the amount, the RBI wants to drain excess liquidity from the system.

Each time, the government bond market bore the brunt of the RBI action. On April 17-18, just ahead of its annual monetary policy, the 10-year bond yield was 7.5 per cent, slightly higher than 7.46 per cent in the beginning of April. It was inching up sensing a rate hike in the policy.

However, with the RBI abstaining from the hike, bond prices staged a rally and the yield on the 10-year paper dropped to 7.35 per cent on April 19 and further to 7.33 on April 21.

Since then, it has been inching up slowly but there was another spike on June 8 with the sudden and unexpected hike of rates by the central bank after market hours. The rate jumped from 7.67 per cent to 7.81 per cent. It touched yet another high of 7.9 per cent when the RBI raised the quantum of market borrowing.

Indeed, there is plenty of liquidity in the financial system. Barring a few days in January and March, the RBI had infused money into the system daily in the last quarter of 2005-06 through its repo window.

The amount of infusion varied between as low as Rs 605 crore (Rs 6.05 billion) (March 13) and as high as Rs 32,575 crore (Rs 325.75 billion) (January 13). Since April, the trend has reversed and the RBI has been sucking out liquidity through its reverse repo window.

In the first week of June, the amount of money sucked out daily varied between Rs 66,000 crore (Rs 660 billion) and Rs 72,000 crore (Rs 720 billion). This week, the average mop up has been around Rs 40,000 crore (Rs 400 billion).

Apart from the reverse repo mechanism, the RBI has also reactivated its market stabililsation scheme to suck out liquidity. This is being done through 91-day, 182-day and 364-day treasury bill auctions.

The treasury bill yields, too are going up. For instance, the yield on the 91-day treasury bill has gone up from 5.74 per cent on May 3 to 6.19 per cent last week. Similarly, the yield on the 182-day treasury bill has gone up from 5.95 per cent to 6.50 per cent and that on the 364-day from 6.25 per cent to 6.48 per cent.

With rising yields, banks will be required to provide for depreciation in their bond portfolios. Naturally, nobody is willing to buy bonds even though there is ample liquidity in the system.

"If we need to meet the SLR requirement, we would rather invest in short-term treasury bills. Who would like to invest in long dated securities when nobody is sure about the regulator's next move?" asks a senior banker.

Traders will be back in dealing rooms only if credit offtake falters and banks pile up funds with no borrowers in sight. With the economy growing at over 8 per cent, this is unlikely to happen.