If you have been looking at the rising bond yields in India over the last one year, it has clearly shown an appreciation of over 130 basis points from a low of around 6.5% last year. Rising bond yields in India come with a plethora of implications as rising bond yields and stock markets tend to be negatively correlated. Is higher bond yield good or bad; that is perhaps a question that cannot have a discrete answer? It would depend on a plethora of factors.
Chart Source: Bloomberg
If you look at the 10-year bond yields in India since the last 1 year, the journey has been in one direction. However, there have been many nuances in this journey. Despite the bond yields briefly crossing the 8% mark, it has settled below the 8% mark. Here are some key facts you should know about rising bond yields in India.
10 things you must know about rising bond yields in India
One of the principal drivers of bond yields in India has been the rate of inflation, especially the rate of CPI (retail) inflation. Since CPI inflation has been journeying up in the 6-8 months, the yields have also followed the similar path.
Apart from the actual inflation level that is announced as the CPI inflation each month, the expectations of inflation are more important. For example if the current rate of inflation is 5% but if the expectation is that inflation will go up to 7%, then that hawkish inflation expectations tend to get reflected in the bond yields.
The monetary policy of the RBI has a major impact on the yields. In the last 1 year, the RBI has been talking about shifting its interest rates policy from dovish to neutral. That was an indication that if the data supported then the RBI would be willing to move the interest rates both ways. That is why the higher inflation was immediately interpreted as a signal of higher bond yields.
Minutes of the Monetary Policy Committee (MPC) are also a critical input for rate decision making. The June meeting of the MPC was the first occasion when all the members of the MPC voted in favour of hiking the rates by 25 basis points. The minutes are normally announced 15 days after the policy announcement and that is a critical trigger for h higher bond yields.
Targeting real interest rates is another trigger for bond yields. In the context of the monetary policy, the RBI has clearly set out a real interest rate target of 1.75% for India. (Real interest rate is the excess of the nominal rate of interest over the rate of inflation). Since the real interest rates are currently at 1.25%, there is a clear reason for a hawkish stand by the RBI. That will mean higher rates and is reflected in bond yields.
Oil prices are putting a pressure on the bond yields. Not only are oil prices a signal of imported inflation but they are also weakening the rupee. That means you have the added problem of stemming the fall in the rupee. Rate hike may be the answer to address both these problems and that is reflected in the bond yields.
There is larger relationship between rate hikes and the rupee value. Since the trade deficit has been on a constant uptrend (currently $16.6 billion per month), there is pressure on the rupee, which has taken temporary support around the 69/$ mark. The best way to strengthen the rupee is to hike rates so that it absorbs the pressure of the rupee via capital flows. That is also leading to higher bond yields.
Capital flows could be the missing link. The FIIs have been net sellers for most of 2018 on fears that risk off selling maybe necessary any time. The markets are betting that to prevent any rapid outflow of capital, the RBI may be enticed to hike rates further, considering that RBI has cut rates by nearly 2.75% since the beginning of January 2015.
The markets are also betting that the RBI may require higher bond yields to ensure that the forex reserves can be shored up. Forex chest has been depleted from $430 billion to around $405 billion as RBI has used up its reserves to defend the rupee by selling dollars. The forex cover is already down to 9 months of imports and higher bond yield may be the answer to attract bulk inflows through FDI and the FII route.
Finally, why have yields stopped ahead of 8%. The markets also feel that the rate hikes may be calibrated. So, while one more rate hike of 25 basis points in this year is on the cards, the RBI would not be too adventurous. They need to match up with US Fed rates but they cannot afford to push up rates to a level where IIP growth suffers. It is this trade-off which is making the bond yields halt below the 8% mark. Greater clarity should emerge in the coming few weeks.