Bond markets have been rejoicing for a while now, first on expectations of a rate cut, then on RBI’s two policy rate cuts since January.
But the euphoria may be short-lived if the rupee continues to weaken.
While the RBI may be drawing comfort from falling retail inflation, the rout in the rupee may put a stop to further rate cuts, or worse, nudge the central bank to increase short-term rates as it did in July 2013.
Last week, the rupee plunged below 64 against the dollar, the first time since August 2013, when it fell to 68 levels.
In the past, bond markets seemed to be accurate in their interest rate expectations. And if one were to go by that, bond markets have been signalling a rise in interest rates over the last couple of weeks.
Yield on the 10-year government bond has risen to 7.98 per cent, an increase of almost 30 basis points since March, when the RBI made its second rate cut.
The yield is now close to 50 basis points above the repo rate (7.5 per cent), the rate at which banks borrow short-term funds from the RBI. In the past, the bond yield moving above the repo rate has been an indication of rates going up. This is in contrast to what happened a few months ago, when the market was pricing rate cuts ahead of the policy actions by the RBI.
In December, the 10-year G-Sec yield slipped to 7.97 per cent — below the RBI’s 8 per cent repo rate then.
At the end of the rate-hike cycle in July 2008, the yield on G-Sec fell below the then prevailing 9 per cent repo rate. From August to December 2008, the yield was consistently 30-50 basis points lower than the benchmark rate. Between July 2008 and April 2009, policy rates were reduced from 9 per cent to 4.75 per cent.
During the rate hike cycle that lasted from January 2010 to October 2011, when the RBI had cumulatively raised the policy repo rate by a total of 375 basis points, the bond yields had started to move higher than the repo rate from the mid-2009 itself.
Bond prices (which move opposite to yields), may continue to be under pressure given that Foreign Portfolio Investors have intensified their selling in debt on account of recent turbulence in global bond markets and a sudden rise in yields.
Earlier measureA sell-off by foreign investors is likely to keep the rupee under pressure.
During 2013, bond markets had witnessed a similar sell-off when there were expectations of a rate hike by the US. The rupee saw a freefall to 68 against the dollar. India’s forex reserves dipped to $275 billion. The RBI had to step in and implement liquidity tightening measures.
Then, the RBI had capped the amount that banks could borrow from overnight markets through the liquidity adjustment facility (LAF).
It also increased banks’ cost of borrowing short term money through the Marginal Standing Facility (MSF) rate by 200 basis points. These measures led to a spike in short term rates.
This time around, India’s forex reserves are in a better position, hovering close to $345 billion.
The RBI may hence pump dollars into the market to prevent the fall in the rupee. But given talks of the rupee once again testing levels of 68 or below, the RBI may be forced to consider alternate actions.