The difference or spread between the yield on 10-year Indian government securities and the yield on US Treasury bonds narrowed in the past one month, signaling a likely slowdown of foreign fund flows to the Indian debt market, experts said.
The difference between the yields was 3.53 percent on May 8 compared with 3.96 percent on April 6, according to data sourced from market participants.
Here is an explainer on why the spread narrowed and what it means:
Why has the difference narrowed?
The Reserve Bank of India refrained from increasing the key interest rate in April while the US Federal Reserve continued with its rate hikes.
This pulled down the yield on Indian government bonds sharply, while US Treasury yields remained mostly range-bound or moved up a little.
In addition, the Brent crude oil prices declined, easing inflationary pressures in India.
Also read: Receding fear of rate hikes, positive global cues create optimism zone for Indian equities
Will this impact foreign flows?
Narrowing of the yield spread usually results in global investors pulling out money from Indian government securities.
“The narrow difference between US and Indian bond yields indicates lower carry trade that will discourage foreign flows,” said Dilip Parmar, a research analyst at HDFC Securities.
Carry trade is a strategy investors use to borrow money in one currency at a low interest rate and invest in a currency that has a higher interest rate, making the return equivalent to the difference between the two rates.
According to Kunal Sodhani, vice president at Shinhan Bank, foreign investors move money from India as investments in the US become more attractive. However, he said the rate trend will determine inflows.
According to data from the National Securities Depository Ltd., net foreign portfolio investments remained negative at Rs 1,689 crore in the debt segment so far in May. In April, the investments were positive, at Rs 806 crore.
Will the spreads narrow further?
Dealers said the spreads could narrow if the US and Indian central banks maintain their respective rate trends.
“The spread could further narrow if the Fed continues to raise the interest rate while the RBI holds the rate unchanged in the upcoming meeting,” said Parmar.
Sodhani said the rate hike trajectory may pause and start to reverse by next year. The spread will depend on who cuts rates more aggressively from next year.
Impact on rupee
The narrowing of interest rates between India and the US makes India less attractive for currency carry trade. When forward premiums are low, it makes carry trade less viable and reduces the willingness of exporters to hedge, which reduces the supply of dollars in the forward market.
In the event of a narrow interest rate differential, the lack of big inflows and the central bank’s intervention could further tighten the range, Parmar said.
The rupee has traded in the 81-83 range against the dollar since October 2022.
Also read: Why is Haryana’s GST collection over four times that of Punjab?
Equity inflows
Foreign investment in equities may continue on expectations of better earnings and growth prospects. FPI investment in equities remained positive at Rs 14,703 crore so far in May compared with Rs 11,631 crore in April.
"In coming days, flows of FPI for Indian markets may remain positive as rate hike trajectory seems to done for now and rate curve may reverse," Sodhani added.
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