Alan Greenspan’s famous conundrum of long-term interest rates drifting lower despite monetary tightening by the US central bank seems to be finding an echo in the Indian bond market. On Tuesday, the yield on 10-year government bonds went down almost to the level it had reached prior to the quarterly monetary policy review.
Rate-sensitive stocks up
Bond yields have been yo-yoing in the past one month. The 10-year yield had fallen from around 9.5% on 10 July to 9.1% just before the policy announcement but had then gone up back to 9.5% after the Reserve Bank of India’s, or RBI’s, policy statement. On Tuesday, it went back to the 9% level. The conundrum is that the bond market has rallied in spite of RBI’s surprise decision to raise repo rates (key lending rates) by 50 basis points and despite the hike in the cash reserve ratio. Recall that, after the rate hikes, several observers said the 10-year yield could go up to 10%.
That’s not all. Interest-rate sensitive stocks, which should have been the most affected by the hike in rates, have rallied strongly in recent days, easily beating the Bombay Stock Exchange’s benchmark index, the Sensex. The Sensex has risen 8.5% between its close on 29 July (the day RBI raised the repo rate) and 5 August. Over the same period, the rate-sensitives have done much better, with the BSE Bankex up 16.4% and the BSE Realty index rising 16.2%. Tuesday’s rally celebrating the fall in international oil prices to $118 (Rs4,991) a barrel was led by bank, realty and auto stocks.
In short, in spite of the central bank’s hawkish stance on inflation in its monetary policy review and although the policy statement makes no bones about RBI’s concerns being more about inflation than about growth, the markets seem to believe that RBI is done with rate hikes. Dealers say the fall in international crude oil prices is behind the rally in long-term bond yields.
As the world economy slows, so will the growth in demand for commodities. The latest reports show that in the second quarter of 2008, the US economy, although boosted by tax rebates, grew at a slower pace than expected. There are also signs that the slowdown is spreading to Europe, with a Bloomberg report claiming that “after dodging the US slowdown last year, the 15-nation euro-area economy may have shrunk in the second quarter for the first time since the common currency’s introduction in 1999.” That has led to a deceleration in Chinese exports. Chinese domestic demand seems to be slowing too, with its July Purchasing Managers’ Index down to 46.2, well below June’s reading of 53. (A reading above 50 denotes expansion; below 50 denotes contraction.) Growth in electricity consumption has slowed, while a Citigroup report on China says consumption as well is showing signs of weakness.
In short, as A. Prasanna, chief economist at ICICI Securities, put it: “Although the fall in Chinese output may have something to do with the restrictions put in place by the authorities during the Olympics, with world growth slowing down, demand destruction is very credible.” That’s reflected not just in the falling price of crude oil but also in the lower demand for other metals. For example, copper prices in Shanghai and London were near six-month lows on Tuesday. The Reuters/Jefferies CRB index, which tracks global commodities markets, is at its weakest since early May. Zinc and nickel prices, too, have plummeted.
That, in turn, has had its effect on the stock markets of the commodity-producing countries. The Brazilian and Russian stock markets, which had shot up when commodity prices were rising, are now falling. The MSCI Brazil index is down 7.7% this month (till 4 August) and its three-month returns are a negative 26.96%. Contrast that to the MSCI India index—up 1.9% this month and a negative return of 12.6% for the last three months.
The same pattern is seen in the currencies of the commodity producers: the Canadian dollar, for instance, fell to its lowest point against the US dollar since 12 September 2007 on Tuesday. The Australian dollar has slumped to its lowest in three months against the US currency.
A change in trend?
In short, stock, bond as well as currency markets may be at an inflection point. The trend of the last few months of higher commodity prices fuelling higher inflation may be turning and inflationary pressures could abate in the months ahead.
The big question is: Will this help turn the tide for India? Lower international oil prices may not lead to lower fuel prices in India, but will mean lower prices of other petroleum products, while the pressure on government finances as a result of issuing oil bonds will also ease a bit. And, since inflation and high oil prices have been the main reasons for the negative view on India taken by foreign investors, the hope is that view may now change.
But, this is what RBI had to say on commodity prices and inflation in its monetary review: “There is a possibility, albeit remote, of a drastic reduction in the level of crude prices in the period ahead. In the event, however unlikely, of international crude prices falling below the level up to which pass-through to domestic POL (petroleum, oil and lubricants) prices in India has occurred, there could be some easing of domestic inflation. There is also a view that international prices of other commodities including metals could also moderate with the slowing down of aggregate demand globally. While such moderation in some global commodity prices in future cannot be ruled out, it is prudent to assume that in all likelihood, the current elevated levels will continue in the near future with added uncertainties.” The central bank’s tone is rather sceptical. Additionally, it’s worth noting that all the symptoms of demand growth, such as rising bank credit and higher M3 money supply growth, are still around. Perhaps that is why liquidity conditions are still tight and most observers expect them to remain so. That will mean an inverted or flat yield curve—at the time of writing, call money rates were higher than the 10-year bond yield.
A note by Lehman Brothers points out: “Feedback from our equity analysts and news reports suggest that price hikes are being contemplated in commercial vehicles, white goods, consumer non-durables, paints, health care and wood product segments. There is a risk of hikes in steel and cement prices once the moratorium to hold prices ends in mid-August.” In short, this is unlikely to be the end of domestic inflation. Globally, much depends on policy action in China, where the authorities have recently shifted to giving priority to growth over inflation control. And then, of course, there will be the fallout of slower growth in the future. But at the moment, the markets are betting the worst is over.
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