India’s central bank has chosen to use its sturdy umbrella of forex reserves to keep the exchange rate from complicating its fight for price stability and that means it has to leave the bond market to fend for itself. Understandably, the bond market is feeling snubbed.Reserve Bank of India (RBI) governor Shaktikanta Das highlighted all the possible ill effects of elevated levels of inflation in his statement on Friday after the central bank’s six-member rate-setting committee voted unanimously for a 50-basis point hike in the repo rate. One basis point is one-hundredth of a percentage point. He also said that the rupee has behaved in an orderly way and that forex reserves are a sturdy umbrella against external pressures on the Indian rupee. The rupee has appreciated roughly 0.5 percent so far on Friday.
The 10-year benchmark 10-year yield surged more than 10 bps to 7.26 percent in a span of 40 minutes, the length of Das’ virtual statement. Jayesh Mehta, head of treasury at Bank of America, pointed out that bond yields had fallen on Thursday on hopes that the recent fall in global commodity prices may have prompted the RBI to go easy on its inflation fight. Some even expected the repo rate hike to be not more than 35 bps. “We saw some getting bullish yesterday in the bond market but what the RBI has done today is really not something unexpected. They have not changed their forecasts either,” said Mehta.
In his statement, Das said that the monetary policy committee believes that sustained elevated inflation could destabilise inflation expectations and harm growth in the medium term. This warrants further withdrawal of monetary accommodation. To be sure, the central bank has reversed almost all of the accommodation it gave to markets due to the pandemic. With the latest hike, the repo rate is back to pre-pandemic levels.
Analysts believe that the RBI is being cautious despite the recent easing in global commodity prices that have lessened the challenges on the inflation front. “Overall, RBI’s action and statement today was not as dovish as we expected. Therefore, it is very likely that the terminal rate in this rate hike episode will be higher than our expectations. We, thus, revise it to 5.75-6% from 5.5% expected earlier,” said Nikhil Gupta chief economist at Motilal Oswal Financial Services Ltd in an email note.
A climbing policy repo rate reduces the interest rate differential between rupee and dollar assets, which could make foreign investors rethink their current exodus from Indian markets. That serves well for the rupee but the central bank’s interventions in the forex market sucks out rupee liquidity. That means domestic investors have less incentive to block their money in government bonds.
For the bond market, the stakes are higher as not only has inflation become volatile but the government’s borrowing programme is far from over. With the RBI unlikely to step in as a buyer, yields are expected to only rise from here on.