The surge in bond yields over the last one month has sent them to their pre-demonetisation levels and logically this would mean that yields now reflect future inflation and interest rates.
The fact that the Reserve Bank of India (RBI) sounded hawkish on inflation indicates that the bond market is finally reading everything right after having believed that demonetisation would mean lower interest rates for a long period.
A look at the spread between the 10-year bond yield and the overnight policy repo rate shows that the market has indeed corrected its folly. This spread is now 60 basis points (bps), a sharp rise from about 15 bps during the two months under demonetisation. One basis point is one-hundredth of a percentage point.
But has the bond market adequately priced in all risks or is there still scope for yields to rise? One look at the spread from a historical perspective indicates that there is still an uphill climb left for yields. During January 2015-April 2016, when the RBI slashed its repo rate by a massive 150 bps, this spread remained around 100 bps. Essentially, long-term yields fell as much as overnight rates.
What dictates this spread is of course liquidity. This spread reduced marginally to around 80 bps after the RBI shifted its stance on liquidity in April 2016. Bonds are fungible and so long as there is free money sloshing around bond buying will never go out of fashion. It is no surprise that public and private sector banks piled up more than Rs 10,000 crore worth of bonds in February as they had been the recipients of a barrage of deposits. The banking system liquidity is around Rs 4 trillion in surplus and with no credit to disburse, much of this will continue to flow into bonds of all tenures.
The rise in US treasury yields and the continued selling by foreign funds are yet to be fully priced into bond yields. In a report on bonds, HDFC Bank Ltd notes that once bonds begin pricing in the expected rise in US rates, long-term yields will begin to climb further. The lender expects this to begin around the second half of 2017-18 and the 10-year yield to rise to as much as 7.30%. The climb in yields has already begun but it is far from over.