India’s bond market - a sea of calm amid global turmoil

If the Indian bond yields fall below US yields, it is quite likely that the Rupee may actually appreciate, due to the interest rate parity principle.

In a world gripped by financial instability and rising interest rates, India’s bond market is emerging as a beacon of stability. The contrasting trajectories of the Indian and US 10-year government bond yields - as depicted in the chart - reveal a fascinating divergence. While the US yields continue to rise amidst concerns over unsustainable debt levels, Indian yields are gliding steadily downward, underpinned by robust macroeconomic fundamentals.

Yield Divergence: A Tale of Two Economies

The red line in the chart above represents the US 10-year yield, which has been climbing persistently, especially since 2020. Mounting federal debt, fiscal deficits, and inflationary pressures have kept US yields elevated, unsettling global financial markets.

In contrast, the Indian 10-year bond yield (yellow line) is on a clear downward trajectory. India was among the fragile five economies during the taper tantrum years of the last decade. This was the time when India’s 10-year bond yields were at 9%, a level that has never been touched again in the last 12 years. The government’s commitment to fiscal prudence, efforts to remove structural inflation, an improving current account position and rising forex reserves have created a strong foundation for yields to stay anchored.

At the bottom of the chart, the blue line depicts the yield spread between Indian and US 10-year bonds. This gap is rapidly narrowing and, remarkably, could soon turn negative - implying that Indian bond yields may dip below US yields for the first time in history. This potential inversion would be unprecedented and could have profound implications.

Implications for Indian Rupee and Economy

If the Indian bond yields fall below US yields, it is quite likely that the Rupee may actually appreciate, due to the interest rate parity principle. Global investors might be drawn to Indian assets not for higher yields - which used to be the case prior to 2013 - but for macroeconomic stability and currency appreciation potential.

As Indian yields decline, the domestic yield curve is also becoming normal and may even steepen with the difference/slope between one year and 10-year yields above 2%. This has significant benefits:
-Borrowers are encouraged to take loans as interest rates are generally low.
-Investors are incentivized to invest in longer-duration instruments for better returns.

This virtuous cycle - characterized by rising investment, job creation, and consumption - was last seen during the golden period between 2003 and 2007, when India posted strong GDP growth on the back of stable fiscal management and rising global confidence.

Equities May Suffer in Short Term, But Long-Term Outlook Bright

In the short term, Indian equities may not be immune to global shocks. As global markets face a reset - driven by geopolitical tensions, huge government debts and structural shifts - Indian stocks could face volatility along with global peers. However, if India maintains its fiscal discipline and macroeconomic stability, it stands poised to lead the global recovery. As it is, India has been the fastest growing large economy for quite some time.

Conclusion

India’s bond market is not just a financial indicator; it is a reflection of the country’s economic resilience. In a world where developed economies are grappling with debt and instability, India is assiduously charting a different course. The potential inversion of India-US yields could be more than a statistical anomaly - it may signal the beginning of a long-term shift in global economic leadership.

Views are personal and do not represent the stand of this publication.