It appears that the Indian sovereign bond market (GSec) is in direct conflict with the contentions of Eugene Fama’s efficient markets hypothesis theory. The American economist suggested that the market gives very little time to financial mavericks to outperform the consensus as it quickly adjusts to any new information introduced, whether public or insider.
With over 250 bps worth of repo hikes delivered over a span of 10 months, the Indian 10-year sovereign bond yield has hardly budged, largely remaining within a range of 7.30-7.45 percent. In the meantime, an equivalent US security is yielding an incremental 165 bps, over the same period. Additionally, at 374 bps, the US-India 10-year GSec differential is now among the lowest points in four years.
Riskier Bet
This is surprising because, despite its bright star credentials, India is an emerging market and a comparatively riskier investment bet. Therefore, when the 10-year bond yields moved just 2 bps as a reaction to the RBI’s February 2023 Monetary Policy Committee’s (MPC) 25 bps rate hike, eyebrows are bound to be raised. Moreover, India’s net debt issuances over the last three years have significantly overshot budget estimates and it is likely that the FY24 number will exceed the Rs 12.2 lakh crore threshold, given the 2024 general elections.
Looking at the ‘actual’ yield curve, the differential between a 30-year and 2-year bond is pegged at 26 bps, the lowest in three years. At the same time last year, the differential was a whopping 222 bps, but this preceded the monetary tightening cycle. The ‘forward’ yield curve calculations on the hand predict a differential of just 13 bps, with a yield curve inversion in the 5 and 10-year duration. What this means is that one year from now, the bond market is predicting that a 5-year bond will yield higher than a 10-year instrument.
As understood, a flattening yield curve is a predictor of an impending recession, and past research suggests that the previous ten US recessionary cycles have been anticipated by an inversion.
Nevertheless, now that the MPC has destroyed all preconceived notions regarding the terminal rate of 6.5 percent, there is a chance that rates may go up further. While this forward march on rates will anchor inflation expectations, there is a high chance that the costs on economic stability will be high, at least in the short to medium term.
Confusing commentary
Accordingly, the Indian bond market seems to be unsure of India’s economic performance as things stand and nothing explains this better than a flattening yield curve. As the terminal rate cannot be realistically predicted given the confusing MPC commentary, bond investors are no longer anticipating a significant return differential between the short and the long end of the curve. Theoretically, when this happens, the longer-duration securities are held for longer and all the action shifts to the shorter duration, accompanied by a lot more volatility.
Regarding the unanticipated yield curve reaction to rate hikes, this author has a four-pronged hypothesis. Firstly, an analysis of the issuance basket planning indicates that the RBI reduced the proportion of 10-year securities from 25 percent in FY22 to 20 percent in FY23. What this move has done is that it has smartly reduced the supply of these securities artificially, lowering the issued value by Rs 22,000 crore in addition to the anticipated increase for the year. This was probably done to calm the markets as the said duration instruments are used as benchmarks.
Happier Banks
Secondly, the record systemic liquidity brought forward from the COVID era has led the RBI to conduct considerable reverse repo operations under liquidity adjustment windows. This resulted in GSecs finding a safe passage into commercial bank balance sheets in exchange for cash.
Since commercial banks use such securities for strengthening their Liquidity Coverage Ratio (LCR) and associated availing facilities they were never happier, lapping up supplies readily. This author’s earlier research has revealed that government securities form over 80 percent of Indian commercial bank treasuries. This has helped contain yields considerably as such securities are mostly held-to-maturity (HTM). Nevertheless, this façade of yield control will last until systemic liquidity dries up on the back of rising credit offtake. Once the credit-deposit ratio normalises, commercial banks will scramble for liquidity and offload securities for cash.
Thirdly, rising interest rates have doubled real returns YoY. What this means is that as on February 8, 2023, a 10-year GSec, which was yielding 7.35 percent, is offering a real return of over 120 bps, when considering the prevailing inflation rate. This return was roughly half, same time last year. Therefore, there is a possibility that some yield chase in the market could control the yields for a brief period, but this cannot be a major reason considering the volumes.
Finally, this could be a passing fad as the yield curve adjusts to the rising rates and may normalise as the domestic macro picture as well as central bank actions in other parts of the world becomes clearer. However, witnessing the evolving bond prices elsewhere in the world, it is apparent that Indian sovereign debt valuations may be at odds with expectations, as the market interprets the missing links. Only time will tell whether this is the calm before the storm.
Karan Mehrishi is an economist, specialising in monetary economics and fixed income. Views are personal and do not represent the stand of this publication.
Discover the latest Business News, Sensex, and Nifty updates. Obtain Personal Finance insights, tax queries, and expert opinions on Moneycontrol or download the Moneycontrol App to stay updated!
