Why bond yields will not harden
The real economic activity, including index of industrial production (IIP), will remain muted for some time
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Indian financial markets often remind us of the famous saying by Keynes: “The market can remain irrational longer than you can remain solvent.” Consider this example. The yields in the G-sec markets, particularly for the benchmark 10-year, have hardened close to 80-90 basis points (bps) since the end of November 2016. But the good thing is that contrary to market perception, yields will soften, even though a rate hike by the US Federal Reserve is likely.
In FY16, the movements in G-sec yields have been a roller coaster, to say the least. A surprise change in liquidity stance by the Reserve Bank of India (RBI) in April 2016 to neutral, accompanied by an easing in the repo rate and the promise of durable liquidity, resulted in the 10-year benchmark yield hovering around 7.5% throughout the first quarter.
However, a global growth scare in June following Brexit resulted in the softening of yields across the globe, with the 10-year US yield touching 1.35%. Indian fixed-income yield also tracked the global fixed-income rally. Subsequently, the 10-year yield hovered between 7.05-7.15% towards the end of the second quarter.
Come October, the newly formed monetary policy committee (MPC) unanimously voted in favour of a further 25 bps easing. The new 10-year benchmark softened very fast to around 6.7%.
Towards the end of October, again there was an element of uncertainty, with the global fixed-income yield hardening, tracking the higher probability of Donald Trump’s win. This spilled over into the domestic market. At that point, India made a historic announcement of demonetization. This phenomenon resulted in decoupling Indian fixed-income yield movement from its global counterpart which, however, continued its northward journey.
Back home, with a surge in systemic liquidity of around Rs6 trillion, the 10-year yield softened to a 6.1-6.2% range, till the time the RBI mopped this through an incremental cash reserve ratio hike and subsequent issuance of cash management bills. But there were surprises to come. Unanticipated status quo in the December MPC meeting, followed by the Fed hike, pushed domestic fixed-income yield higher to around 6.55%, in line with the global trend (US yield at 2.6%) by the end of the year.
The beginning of the fourth quarter saw government reducing dated securities borrowing by Rs18,000 crore and treasury bill borrowing by Rs52,000 crore. Additionally, there was a sizeable G-sec redemption of around Rs65,000 crore in mid-January. Despite all this, the 10-year yield surprisingly did not sustain below the 6.40% mark because of lack of market appetite and the spread of the medium end (15-20 year segment) over the 10-year widened and very long end paper devolved at a higher spread. However, with the MPC changing its stance from accommodative to neutral in its February policy, the 10-year yield jumped close to the 7% mark. Since then, there has been an abundance of market commentaries that yields will sustain at this level. We, however, believe otherwise. Let us see why.
First, following Trump’s win, the 10-year US yield jumped from 1.72% in November 2016 to 2.6% in mid-December 2016. Since then, the 10-year US treasury yield is moving in a narrow band of 2.30% to 2.50%. Recent market movement suggests that at the current level, two 25 bps hikes in Fed rate are already built in. Hence, until and unless the Fed is through with its second hike, probably in mid-June or late July, any pressure from that front is less likely.
Second, the Central Statistics Office retained its gross value added (GVA) forecast at 6.6%. There is higher likelihood that this will undershoot the RBI’s assessment of 6.9%. Thus real economic activity, including index of industrial production (IIP) and movement of leading indicators, will remain muted for some time. This is also borne out by our assessment. Curiously, yield spread in India has widened to 80 bps from 30 bps a month ago (long term), not because of a possible surge in economic activity, but purely because of temporal demand supply mismatch.
Empirical evidence also supports the argument that monetary policy along with real economic activity too has an impact on slope, level and curvature of the yield curve in India. For example, Rudra Sensarma and Indranil Bhattacharyya showed in 2015 that once the beneficial impact of monetary policy actions in terms of stable inflation expectations is factored in by market participants, real economic activity plays an important role in determining yields across maturities. With IIP numbers currently weak, it remains to be seen how that could also act as an enabling factor in pushing down yields.
Last but not least is the demand-supply balance. Though, in recent times, UDAY and state development loans (SDL) supply remained a cause of concern for the market, its supply will fade away post 15 March, at least for the next four months. Analysis of past data with respect to state borrowing shows that during the first half, it remains muted, and the entire borrowing is skewed towards the third and fourth quarters. Lesser SDL supply coupled with Rs1.11 trillion central G-sec redemption is likely to balance the demand-supply equation at least until July.
Combining all the above-mentioned factors, in the near future 10-year yield is likely to decline from current levels and it may not be entirely unlikely that the yields move closer to 6.6% at some point.
Soumya Kanti Ghosh and Ramkamal Samanta are, respectively, group chief economic adviser, State Bank of India, and vice-president (treasury) SBI-DFHI.
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