10-year bond, repo rate gap shrinks to over 5-year low. Are we near a rate-cutting cycle?

10-year bond, repo rate gap shrinks to over 5-year low. Are we near a rate-cutting cycle?

The spread between 10-year government securities (G-Sec) and the repo rate shrunk to over five years low on May 25, which dealers attributed to a sharp fall in bond yields amid rising demand for bonds.

Bond prices and yields move in the opposite direction. Repo is the rate at which the Reserve Bank of India (RBI) lends short-term funds to banks.

Typically, the spread between long-term bond yields over the repo rate narrows closer to the start of a rate-cutting cycle. But at this stage, the probability of a rate cut in 2023 looks very slim given that retail inflation remains the above medium-term target of RBI, dealers said.

According to the data compiled from RBI and CCIL, the spread between 10-year G-sec and repo rate was 50.04 basis points (Bps) on May 25, as compared to 49.20 bps on May 24.

This is the lowest level since September 6, 2017, when the spread was at 50.70 bps. One basis point is one-hundredth of a percentage point.

Pankaj Pathak, Fund Manager- Fixed Income, Quantum Mutual Fund, said demand was high from mutual funds and insurance companies in the last two months besides likely buying from Russian exporters.

A lower supply of state government bonds than the indicative calendar also aided the easing bond yields, he said.

What does the narrowing of the spread signify?

Sanjay Pawar, Fund Manager – Fixed Income, LIC Mutual Fund Asset Management, said often market tends to price in rate action in yields much ahead of actual policy action. “Spreads have narrowed further as the market's terminal rate expectation might have changed with the RBI keeping the policy rate unchanged in its latest policy and inflation easing,” Pawar added.

On the inflation front, Pawar said that with an expectation of a normal monsoon, inflation may remain closer to 5 percent in the near future which is very much within the RBI tolerance band of 2-6 percent.

India's headline retail inflation rate dropped sharply for the second month in a row, hitting an 18-month low of 4.70 percent in April, according to data released by the Ministry of Statistics and Programme Implementation on May 12.

The RBI in the April monetary policy projected CPI inflation to moderate to 5.2 percent for 2023-24.

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G-sec yield movement

The yield on the 10-year benchmark 7.26 percent 2033 bond fell from 7.45 percent in February, to below 7 percent this month.

Currently, the 10-year benchmark bond yield is trading at 7.0004 percent.

Most correction took place after the RBI in its April monetary policy refrained from hiking rates, after continuous increases since May last year.

The Monetary Policy Committee kept the repo rate unchanged at 6.50 percent in April, after raising it by 250 bps from May 2022.

The fall in government bond yields was also aided by easing Brent crude oil prices and US Treasury yields.

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What’s the way ahead for bonds? 

Money market dealers are of the view that long-term bonds may face pressure from the increasing net supply in the second and third quarters of the current financial year.

According to the borrowing calendar for April-September, government securities worth Rs 6.47 lakh crore are due for issuance till the end of September.

On the other hand, the market conditions for short-term bonds have changed favourably with a pause in rate hikes and easing liquidity due to RBI’s dividend payment to the government and deposits of Rs 2,000 notes after the RBI’s announcement to withdraw them from circulation.

The yield on certificates of deposit (CD) has fallen 15-20 basis points since the last week on expectations of an improvement in banking system liquidity.

Pathak said a combination of various factors along with a cyclical decline in cash demand between June and August should substantially ease the liquidity conditions in the coming months.

“This should bring down money market rates and yields on short-term bonds over the next 2-3 months,” he added.