April’s inflation shocker indicates that the Reserve Bank of India (RBI) will have to prioritise taming price pressures in the economy and allowing bond yields to rise.
A majority of economists and money market experts Moneycontrol spoke to, on May 13, said that the RBI may not aggressively defend the rise in bond yields, and will continue withdrawing surplus liquidity and policy normalisation at a faster pace to bring inflation within its target band.
According to Debendra Kumar Dash, head of fixed-income at AU Small Finance Bank, there is “no scope” for the RBI to keep yields lower or conduct OMOs (open market operations), at a time when inflation is rising.
“The bond market will be without support for the next three months at least, and a rise towards 7.80 percent on the benchmark yield is inevitable,” Dash added.
Data released on May 12 showed that retail inflation in April spiked to an eight-year high of 7.79 percent, 84 basis points higher than the March number of 6.95 percent. One bps is one hundredth of a percentage point.
April’s print topped the upper band of the RBI’s tolerance ceiling for the fourth straight month. Under the inflation targeting framework, the RBI is mandated to target inflation at 4 percent, with a tolerance level of two percentage points on either side.
The bond market has been dreading last week what the latest inflation number might be after the Monetary Policy Committee (MPC) voted in favour of a 40-basis-point repo rate hike on May 4 at the conclusion of an unscheduled meeting.
The repo rate is the rate at which the RBI lends funds to banks. It currently stands at 4.40 percent. The MPC’s next meeting is scheduled between June 6 and 8.
Already, a record debt supply, aggressive policy normalisation by the US Federal Reserve and elevated commodity prices have pushed bond yields higher. The yield on the benchmark 10-year bond had surged to a three-year high of 7.49 percent on May 9, up from 6.9 percent on April 4.
Today, the yield rose to as high as 7.34 percent intraday, up 10 basis points from yesterday’s close. Currently, the bond market has priced in repo rate hikes for up to 75 basis points in the June and August meetings, economists said.
“We expect inflation to average 6.7 percent by the end of FY23, necessitating a front-loaded policy withdrawal,” said Upasna Bhardwaj, senior economist at Kotak Mahindra Bank. “From the current levels, we pencil in cumulative rate hikes of 90-110 bps in the rest of 2022, with a repo rate hike of 35-40 bps and another hike in Cash Reserve Ratio of 50 bps in the June policy.”
Cash Reserve Ratio, or CRR, is a percentage of deposits that banks must hold in liquid cash. This month, the RBI hiked the CRR to 4.5 percent from 4 percent.
Bond market pain to accentuate
The RBI, as the government’s debt manager, is expected to smoothen the borrowing plan and keep the sovereign’s borrowing costs low. Typically, the central bank manages bond yields by buying bonds from the open market and incentivising banks to buy bonds via various tools.
In the current scenario, this is like walking a tightrope for the central bank as it has the uphill task of combating inflation, sucking out surplus liquidity and protecting a falling rupee. Bond prices and yields move in opposite directions.
“Higher (bond) yields are consistent with the RBI's abrupt shift in policy stance, higher inflation and global yields,” said Abhishek Upadhyay, senior economist at ICICI Securities Primary Dealership.
“Hence, on the one hand, when the RBI is aggressively sucking out excess liquidity from the banking system, and trying to send signals on curtailing a sharp decline in rupee, OMO may end up confusing the bond market,” Upadhyay added.
When the RBI buys securities from the open market, it creates additional liquidity in the system. Of late, the central bank has been selling bonds in the open market to manage the liquidity in the system. According to data from the RBI, it sold government bonds worth a net of Rs 870 crore since April 1 in the open market in its bid to suck out excess liquidity.
In such a scenario, the RBI also has the option to opt for a special OMO, in which it simultaneously buys longer-dated securities and sells short-end notes of a similar amount. This tool is used to alleviate the problem of liquidity addition and at the same time, keep the lid on soaring bond yields. The RBI last conducted a special OMO in September.
In the current scenario, “special OMOs or Operation Twist, while an attractive option to ease term premia, may be constrained as the residual maturity profile of government bonds in the RBI's book could be thin,” said Madhavi Arora, lead economist at Emkay Global. “We maintain that a mild bear-flattening bias in the bond yield curve may prevail.”
Bond market experts said that the RBI’s constraint to intervene heavily in the debt market signals that yields are likely to rise further from the current levels as the RBI continues with the removal of policy accommodation.
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