Bond market says easy money is over but Omicron could test this

The yield on India’s 10-year government bond has crossed pre-pandemic levels even though the country’s central bank made it clear only two weeks ago that it was not ready to roll back its growth-centric stance.

Nothing seems to be going right for the bond market. The threat of inflation has only grown, most central banks are rolling back easy money, and the Reserve Bank of India isn’t interested in being the big buyer of bonds it was in previous years.

Global commodity prices are on an upswing, although the rally is getting some resistance due to the spread of Omicron, the new Covid-19 variant. Back here, a record high wholesale price index inflation doesn’t augur well for retail prices. It’s only a matter of time before consumers begin to feel the pinch of rising prices, warn economists. That could potentially increase the pace of normalisation by the RBI.

This brings us to the key factor behind the sharp increase in bond yields in the past few weeks. Sure, the RBI has reiterated an accommodative monetary policy, but its move to nudge overnight interest rates towards the repo rate of 4 percent has begun to reflect across the sovereign yield curve.

The central bank mopped up Rs 2 lakh crore through a seven-day variable reverse repo rate (VRRR) auction at 3.99 percent on December 21.

Bond investors pointed out that VRRR auctions have brought overnight rates closer to 4 percent, which is the repo rate, from 3.35 percent (the reverse repo rate).

The government issues bonds to raise money to meet its expenditure, while the yield is the annual return on a bond. Bond yield and prices move in opposite directions. When yield goes up, the borrowing cost for the government, which is the biggest issuers of bonds, also rises.

Excess liquidity

R Sivakumar, head of fixed income at Axis Mutual Fund, said the movement of overnight interest rates closer to 4 percent post-VRRR has made the entire curve shift upwards.

“We have seen the overnight liquidity dropping to less than 1 trillion rupees now. In essence, all excess liquidity is now going at 4 percent rate, which is the repo rate,” he said.

Since hacking off at the unprecedented liquidity surplus is daunting, the central bank has resorted to raising the cost of this liquidity through VRRR. This has had the desired effect.

Yet another reason for concern is another year of a large supply of bonds as the government prepares to announce its budget for fiscal 2022-23 in February.

Bond traders don’t expect the Centre to cut down on its borrowing beyond a few zeros. Considering that the RBI may not be a big buyer, the onus of absorbing the supply will fall entirely on the market. Note that the central bank has bought over Rs 2 lakh crore worth of government bonds so far in FY22.

One factor that could bring relief to the bond market is the Omicron threat. While the case load in India hasn’t reached worrying levels and a steady vaccination pace has helped, the second wave experience has kept investors sceptical. But so far, economic activity levels have remained buoyant.

“Domestic economic activity so far remains unaffected by Omicron concerns. True enough, Covid infections still remain low in India and continue to trend lower on a seven-day moving average basis (waning below 7k/day – a level last seen in May 2020) with the total Omicron case tally at 174,” economists at independent research firm QuantEco Research wrote in their note.

For now, the bond market is occupied with the inflation threat and the normalisation of policy. The threat of Omicron to economic recovery remains, but isn’t big enough to sway the RBI’s normalisation speed.