A fall in prices coupled with the government’s clear commitment to inflation control should lead to significantly lower policy rates
The bond yields have dropped in response to the Union Budget and the February monetary policy review. Now, the question that seems to be on everyone’s mind is, where do yields go from here? Is the rally over?
To be sure, the Budget was largely positive for the bond market. Fears with regard to a larger fiscal deficit proved to be unfounded and everything the bond market could expect was delivered. In fact, certain measures that increase foreign investor participation and support inclusion in international indices went beyond market expectations.
Along with the fiscal deficit glide path, which is expected to come off from the current level, this triggered an immediate positive market response, with the benchmark 10-year yield dropping by 10 basis points (bps).
Next came the Reserve Bank of India’s first monetary policy review of this decade. While it has been touted as the RBI’s “whatever it takes” moment, it stopped well short of that. However, as with the Budget, the monetary policy was largely positive for the bond market, with the benchmark 10-year yield falling 5 bps.
One percentage is 100 bps.
The market was particularly enthused by the Long Term Repo Operation (LTRO) by the RBI, which seems to target lower short-term yields by giving up 15 bps in the 1-3 year yields immediately. In essence, after the Budget and the monetary policy, the entire yield curve moved lower with the 3-5 year segment falling the most.
With the Budget and the RBI’s February policy behind us, it’s time to take a look at their long-term impact on market direction and analyse likely policy rate changes in coming days as well.
There is little doubt that the long-term impact of the Budget measures aimed at boosting participation is a positive for the market. As far as the monetary policy is concerned, the impact will depend largely on continuation and furtherance of the steps announced.
To ascertain whether all these will have an incremental effect on bond yields requires one to look beyond the measures per se and at the intention underlying them.
An important factor that will influence the general direction of yields going ahead is the efforts of the government and the RBI to improve transmission of policy rates to market yields and lending rates. Be it the pre-Budget Operation Twist, the Budget announcements or the RBI’s LTRO initiative, all point to the prevailing concern that market yields are higher than warranted, as visible from term spreads.
The term spread is a barometer of the difference between the coupons, or interest rates, of two bonds with different maturities or expiries.
By signalling that the fiscal deficit will be restrained, the government has put its focus on inflation control clearly once again. The fact that the government chose inflation over an economic stimulus at the time of a slowdown underscores its commitment not only to lower systemic inflation, but also to a softer interest rate environment.
As I have written earlier, it’s apparent that the RBI’s focus on headline inflation to set interest rates is wrong. The headline inflation is affected by foreign factors such as oil and other commodity prices. Also, its response gets diluted by the demand-supply dynamics that is outside the scope of monetary policy (for instance, food prices). As a result, core inflation, which excludes food and energy prices, is a significantly superior input from the policy perspective.
However, the RBI contends that food prices feed into core inflation through inflationary expectations. Its monetary policy framework models a policy response to food inflation through an equation incorporating this belief.
What the equation ignores is the conditionalities and the lags at play. It is this gap which makes the prevailing monetary policy environment out of sync with the current economic realities. Despite subdued core inflation and depressed economic activity, real interest rates remain extremely high, primarily in response to high food and vegetable prices.
Going forward, as seasonal and supply side factors influencing food and vegetable prices normalise, the headline inflation will start to fall. This combined with the government’s clear commitment to inflation control should result in significantly lower policy rates.
Seen along with the currently elevated term spreads and the apparent intent to see these shrink, it is clear that the recent fall in bond yields is just a precursor of what’s to come.
Bond yields have just about started falling and have a long way to go. You can count on it.
Rajiv Shastri is the former CEO of Essel Mutual Fund and a debt market specialist. Views are personal.