Bond yields haven’t fallen as much as expected in the two months since the Reserve Bank of India’s (RBI’s) last monetary policy review. If anything, the yields of the benchmark 10-year government bond have risen 7 basis points. Even one- and two-year government bond yields have increased by similar levels. One basis point is one-hundredth of percentage point.
This has happened despite RBI pumping in Rs.70,000 crore liquidity in the past two months via open market bond purchases. Citigroup says that is 60% of central government paper issued this financial year. That is of course in keeping with the central bank’s policy of moving banking system liquidity from a deficit to neutral.
Indeed, as the chart below shows, the banking system had an average liquidity deficit of Rs.65,000 crore last week, compared with Rs.1.2 trillion two months ago. But it doesn’t seem to have helped because the bottom line is that the system is still in a deficit mode. While the progress to a liquidity-neutral situation will take some time, note that the markets are also waiting for clues about the liquidity walkaway that could happen in September when FCNR (B) bonds worth $15 billion come up for redemption.
What are the other reasons for the bond yields to remain stubbornly range bound?
Let’s set aside the 7.9% GDP (gross domestic product) growth as a factor because nobody in the market really believes in it.
The primary reason seems to be fears of inflation resurfacing. Consumer price inflation jumped to 5.4% in April from 4.8% the previous month. The unprecedented heatwave of the last two months have stoked food inflation, which increased to 6.3% in April. That remains a key risk even after the Indian Meteorological Department has forecast 0% possibility of a deficient monsoon. Historically, there is at best, a tenuous link between good rains and easing food inflation.
Leave alone food, even core inflation is in the danger of increasing as oil prices (and those of other commodities) have climbed steadily. After 15 months in deflation territory, wholesale price inflation has again started inching up.
The second reason for sticky bond yields is the noises coming from the US Federal Reserve. On 27 May, chairperson Janet Yellen said that an interest rate hike is “probably” appropriate in the coming months. That would, of course, lower the arbitrage between US and emerging market rates, making the latter less attractive to global investors.
Indeed, foreign institutional investors have been lackadaisical in bond buying this calendar year. They have pulled out a net Rs.6,700 crore so far.
The question is, if the US Fed defers its rate hike (the jobs report released on 3 June shows the weakest growth in five-and-a-half years), will that lead to the bond yields finally moving down?