If the inflation remains high, the central bank may stay on hold for a prolonged period. Coupled with likely high government borrowing, bond yields could rise further, no matter what RBI does.
How effective has been Reserve Bank of India’s (RBI) ‘Operation Twist’, the simultaneous sale and purchase of government bonds, in achieving what it originally intended to do—bring down the longer term yields? After three tranches of ‘Operation Twist’, the yield on the 10-year government bond had eased about 20 basis points (bps). One bps is one hundredth of a percentage point. But with inflation inching up in December to 7.35 percent in December hit by rising food prices and surpassing most estimates, the 10-year yield has climbed up a bit eroding some of the gains due to RBI’s earlier intervention. At the time of filing this piece, the 10-year yield is at 6.615% from its previous close of 6.627%. Since the operation was first announced on December 19, 10-year G-Sec yields have fallen by 19 basis points from 6.746 percent to 6.551 percent, to bounce back later. So far, in three tranches of 'Operation Twist', the RBI has bought bonds worth Rs 30,000 crore and sold Rs 25,326 crore worth of securities.
What lies ahead?
The answer clearly depends on two key factors. One, how the inflation trajectory is shaping up from this point and two, what does the government plan in term of borrowing for next year, said D K Joshi, chief economist at Crisil rating agency. “If inflation stays high and government decides to spend more to revive the economy, it will affect yields,” said Joshi.
Both are probabilities that are difficult to predict at this point. For example, no economist expected the inflation to jump to 7.35 percent in December, the highest level in 65 months. But costlier food prices drove the headline number higher. How will food prices behave going ahead? “That’s difficult to predict but there should be some softening,” Joshi said. Food inflation rose to 14.12 per cent in December as against 10.01 percent in the preceding month while core inflation that excludes volatile components inched upto 3.54 percent in December. In January too, there is a possibility that print will remain high because of unfavourable base effect. This is because in January, 2019, consumer inflation inflation had fallen below 2 percent.
If inflation stays high, the RBI will be wary of lowering interest rates. True, it may not raise rates in a slowing economy, but even a pause in rate cut can push up bond yields.
The next trigger will be government borrowing plan for next year. The economy is in a bad shape in terms of growth. The GDP growth for the full fiscal year is expected to come at 5 percent for the full year, the lowest level in FY20. This would mean unless government keeps the spending high, chances of further downslide is likely. The factory output generally indicates that there are no strong signs of revival yet. In this context, government could announce a bigger borrowing programme for next year in the February budget. If that happens, yields could move up even sniffing the 6.80 percent -7 percent level, dealers said citing the expected additional supply to the market.With the RBI having little ammunition to keep the yields in a range, the effectiveness of the ‘Operation Twist’ hangs in balance.Get access to India's fastest growing financial subscriptions service Moneycontrol Pro for as little as Rs 599 for first year. Use the code "GETPRO". Moneycontrol Pro offers you all the information you need for wealth creation including actionable investment ideas, independent research and insights & analysis For more information, check out the Moneycontrol website or mobile app.