* Benchmark 10-year bond yield falls to lowest in two months
* State-run banks refuse to lend bonds in repo on surplus cash
* Traders cut loss after massive short positions left uncovered (Updates repo volumes, closing level)
By Suvashree Choudhury
MUMBAI, April 3 (Reuters) - India's benchmark 10-year bond rallied to its highest level in two months, as traders who had shorted the debt rushed to cover positions by buying the paper in spot markets after being unable to secure them through the inter-bank repo market.
The scramble for bonds came after some traders on Friday shorted the 6.97 percent bond due in 2026 and needed to secure the bonds on Monday to settle their trades.
Typically traders don't need to buy the debt outright; they can instead borrow the bonds to settle the trades. But state-run banks on Monday refused to lend out bonds in the repo market, forcing the traders with short positions to buy the debt in spot markets in what is known as a "repo squeeze".
As a result, the 2026 bond yield fell as much as 14 basis points to 6.55 percent, its lowest since Feb. 8, from Friday's close of 6.69 percent.
It ended at 6.65 percent, as banks started lending out some of the securities in repo markets - with repo volumes doubling to 66.67 billion rupees ($1.03 billion) from early trade - which helped ease up on short-covering.
Earlier in the day banks were reluctant to lend out cash saying they didn't need more funds since the sector was already flush with cash, after a ban on higher-value banknotes last year led to a surge in deposits.
"If I add more to the cash...I will have to answer to my top management and there will be an audit of my positions as well," said a senior treasury official at a large state-run bank, declining to be named, given the sensitivity of the issue.
"Why should I take such headache to make money for just one day?"
The incidents on Monday mark the latest repo squeeze to take place in India since the note ban. The last repo squeeze took place on March 3.
The short positions were placed on Friday as some traders bet prices would fall after state-run banks bought 150 billion rupees ($2.31 billion) of bonds in the last day of the 2016/17 fiscal year.
Traders predicted the bond rally would likely reverse itself once the short positions are settled, with caution likely to grow ahead of the Reserve Bank of India's policy meeting on Thursday. Most analysts expect no change in interest rates.
"Everyone is scrambling to meet their delivery obligations today to avoid a regulatory default but there are no stocks available," said a senior official at a primary dealership firm. ($1 = 65.0200 Indian rupees) (Reporting by Suvashree Dey Choudhury; Editing by Randy Fabi and Sunil Nair)