US-Iran war: How is the Middle East conflict shaping India's bond market?

The ongoing conflict in the Middle East, with the US and Israel-led attacks on Iran and the strong retaliation by the Islamic state, has put the global investors on edge and oil prices on a boil.

This situation does not bode well for the equity and bond market investors. The signs of a bloodbath on Dalal Street are clearly visible as crude prices surge past the $86 per barrel mark. The oil prices are forecasted to cross $100 if signs of peace don't materialise.

Every $1 increase in crude raises India’s annual import bill by approximately $2 billion. Brent crude futures have surged 20% this week.

Prolonged tensions have increased logistics and marine insurance costs, disrupting Gulf shipping routes, with many companies now declaring Force Majeure. Oil prices started rallying since Saturday when Tehran stopped tankers from moving through the Strait of Hormuz, which handles roughly 20% of global daily oil supply and over 40% of India’s crude imports transit.

"A sustained oil price shock would expand the current account deficit and exert pressure on the Indian rupee amid a broader global flight to safe-haven assets and potential capital outflows," said Amit Modani, Senior Fund Manager, Lead – Fixed Income, Shriram AMC.

The transmission channel is clear: higher crude increases inflation risk; higher inflation pushes bond yields up; and rising yields compress equity multiples.

Against this broader, Nifty 50 index has crashed over 700 points or 2.8% in the truncated week. But the bond market surprisingly has maintained its ground.

RBI to the rescue

The 10-year government yield is currently trading at 6.67%, similar to the levels prior to the start of the US-Israeli war with Iran. Last Friday, bond yields had ended at 6.6601%. Bond yields and prices move in opposite directions.

The yields have largely held firm amid the Middle East crisis that has lifted crude, as steady demand from the "others" investor category has put a floor under prices, suggests a Reuters report.

The category, which includes the Reserve Bank of India (RBI) among other participants, has net bought ₹56,000 crore of bonds over the last four sessions, per clearing house data shared by Reuters, boosting demand even as sentiment remained cautious.

Murthy Nagarajan, Head-Fixed Income, Tata Asset Management, said that developed markets' yields are lower due to the expectation of a growth shock due to this geopolitical conflict. He, however, expects the emerging markets to be hit with higher inflation and lower growth. In the Indian Context, CPI inflation is expected to be around 4%.

However, he said the bond markets will be stable amid the crude oil shock, the RBI and government will work together to minimise the impact by keeping easy liquidity and tapping into their strategic oil reserve.

But with inflation expected to rise to the higher end of the RBI's range, rate cut expectations have taken a back seat. "Rising crude prices and currency pressures could influence the policy stance of the Reserve Bank of India, reinforcing expectations of a higher-for-longer interest rate trajectory," opined Modani.

What should investors do now?

Tata Asset Management's Nagarajan said that investors should focus on fundamentals as markets will stabilise in the coming month. He expects the market to factor this dynamic in a similar way to the Russia-Ukraine conflict.

"Investors who have a longer-term focus should be in short term and corporate bond funds, due to the attractive carry available in these schemes. Investors having less than 6 months' view should be in ultra/money market or low duration funds," he opined.

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