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* 1-yr OIS rate at 7.46 pct; 5-yr OIS at 7.47 pct
* Disinversion sparked by 5-yr OIS rate surge in June
* Spread between both ends to remain narrow
By Subhadip Sircar
MUMBAI, July 5 (Reuters) - India's swap rate curve briefly disinverted on Friday for the first time in more than two years, signalling the improvement of liquidity in the financial system and expectations the central bank will not continue to cut interest rates this year.
The 5-year overnight index swap rate rose above the 1-year rate at one point, in what is known in markets as a disinversion, bringing the spread more in line with a typical situation in which longer-dated securities should yield more than shorter-dated equivalents.
However, in India, the normalisation of the Indian swap curve has been caused by a bear steepening trend that happens when the longer-end is rising faster than the shorter-end.
The 5-year OIS rate has surged as investors no longer expect the Reserve Bank of India to cut interest rates this year, given a slump in the rupee to a record low that has revived inflationary worries and raised concerns about the financing of a record high current account deficit.
Although this disappointment about rate cuts has also pushed up the 1-year OIS rate, the pace of the rise has been slower than the 5-year after the government increased its spending in June, helping ease tight liquidity conditions.
"The market is concerned that rupee depreciation will exert upward pressure on inflation. So the market is unwinding its rate cut expectations," said Nagaraj Kulkarni, rates strategist with Standard Chartered Bank in Singapore.
India's swap curve had been inverted - an atypical situation when the 1-year rate is higher than the 5-year - since May 2011 following a series of RBI rate hikes that raised interest rates to as high as 8.50 percent in October 2011, while liquidity remained tight.
The moves on Friday reversed that, sending the 5-year OIS rate to as high as 7.4750 percent, above the 1-year OIS swap rate high of 7.46 percent.
Rates at both ends surged in June as the rupee's slump to a record low of 60.76 sharply reduced expectations the RBI will continue to cut the country's key lending rate, or repo rate, after lowering it by 1.25 percentage point since April 2012.
The 1-year OIS rate is now trading at 7.46 percent, well above India's repo rate of 7.25 percent.
Rising swap rates also reflect surging U.S. Treasury yields that have narrowed the differential with domestic yields, thus denting the appeal of Indian debt. As a result foreign investors have sold more than $7 billion in domestic debt since May 22.
However, the 5-year swap rate has risen far faster than the 1-year as eased liquidity conditions, which tend to most impact near-end rates, have eased considerably.
Lenders' borrowings from the central bank have now dropped to a nine-month low of 76.95 billion rupees ($1.28 billion) on Friday, sharply down from 1 trillion rupees in most of May.
Eased cash conditions come as Finance Minister Palaniappan Chidambaram has been asking government departments to speed up spending in a bid to boost an economy that grew at the slowest in a decade in the previous fiscal year.
Meanwhile, the RBI has also cut the cash reserve ratio - or the amount of funds lenders must park at the central bank - by 200 percentage points since January 2012.
The eased liquidity could be positive for the economy, allowing the RBI's rate cuts to filter through more easily through the financial system.
The 1-year OIS was last trading up 6 bps at 7.46 percent, while the 5-year was up 9 bps at 7.47 percent. ($1 = 60.1150 Indian rupees) (Reporting by Subhadip Sircar; Editing by Rafael Nam & Kim Coghill)
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