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How and why does monetary policy impact debt markets?

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10 Feb 20206 mins readBy MOFSL

The debt markets in India consist of the long term debt market and the short term money market. The trade in debt below a maturity of 1 year is typically a money market transaction while the trade in debt beyond a maturity of 1 year is a bond market transaction. The RBI monetary policy has an impact on the long end and the short end of the debt markets. Let us understand how does monetary policy affect the bond market? Remember, monetary policy and bond market are very closely related since the direct impact of rates are immediately felt on the price of bonds. Monetary policy of the RBI covers rates, liquidity and policy for investment in government debt by banks and FPIs. Here is why there is a distinct impact of monetary policy on investment.


Rate announcements and bond markets

Fundamentally, there is a negative relationship between interest rates in the market and bond prices. When rates go up, bond prices tend to come down and when rates go down then bond prices tend to go up. Why is this so? Let us assume that you are holding an 8% bond maturing after 7 years. If the RBI cuts rate by 2% then you are at an advantage because you are locked in at 8% returns while fresh investors will get 2% lower. This advantage tends to get reflected in higher prices so that the yield to maturity (YTM) is maintained at the market level. In case you are holding government bonds or G-Sec bond funds, then you stand to benefit from falling interest rates as you gain from capital appreciation. That explains why G-Sec funds normally tend to outperform when the rates are falling. Longer tenure funds gain more when rates are falling.

 

Rate expectations and bond markets

When it comes to bond markets, at least when it comes to long term bonds, it is the rate expectations that matter more than the actual rate announcements. The yield curve of the 10-year benchmark typically reflects the rate expectations and these rate expectations are set by the RBI in the monetary policy. Look at the chart below..


                                          Source: Bloomberg

The chart above shows the 10-year bond yield movement over the last one year. Take three distinct situations here. The February 2017 monetary policy was the first time the RBI hinted at a shift from accommodative policy to neutral policy. Immediately after that there was a sharp spike in the bond yields. Post April 2017, the yields again started falling as lower inflation and an ambiguous US Fed built expectations of further rate cuts by the RBI. That was reflected in the yields falling. However, post June 2017 when the inflation bottomed out, the bond market has been betting on an end of the rate cut cycle. During the last 6 months despite the RBI not tinkering with rates, the bond yields are actually up by 80 bps. This shows the market expectation that due to higher inflation and Fed hawkishness, the RBI may be impelled to hike rates in 2018. Monetary policy signals and expectations also play a key role in the direction of the bond markets.


Market Liquidity and bond markets

Apart from rate outlook, the RBI also gives critical signals on liquidity. The RBI normally tweaks liquidity in the system through its open market operations (OMOs). While liquidity may not have a great impact on long term bonds, it is the most important driving factor for the money markets, which represents the debt markets at the short end of the yield curve. Typically, when the RBI hints at surplus liquidity in the system the short term rates tend to go down and when the RBI hints at tight liquidity in the system then the short rates tend to go up. This liquidity management is critical in shaping the yield curve of the debt markets.

 

Triggers demand and supply of bonds by banks and FPIs..


Two of the major buyers of government bond issues are banks and FPIs. Typically banks and Foreign Portfolio Investors (FPIs) will decide their bond purchase strategy based on the outlook for rates and the yields. Banks normally prefer a falling interest rate scenario as it will lead to capital appreciation on their bond portfolios. This allows these banks to book treasury profits. A falling interest rate outlook enables the government to raise debt at lower yields. On the other hand, FPIs determine their bond appetite by 2 key outlooks that are provided in the monetary policy. Firstly, FPIs look at the spread of the Indian benchmark yield over the yield in a matured market like the US. Indian bonds have typically traded at a premium of 400 basis points over the US benchmark yields. This is good enough to attract the FPIs. However, if that spread was to narrow, then there could be risk-off flight from Indian bonds, on the lines of what we saw in 2013. Secondly, the monetary policy also gives a currency outlook and that is critical for FPIs. The 400 basis points spread are meaningful only if the INR is stable vis-à-vis the dollar.
In a nutshell, the monetary policy has important implications for the bond markets; in terms of rates, in terms of liquidity and in terms of institutional appetite!
 

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Disclaimer: The stocks, companies, or financial instruments mentioned in this blog are for informational purposes only and should not be considered as investment recommendations. It is advised to consult with your financial advisor before making any investment decisions. Investment in securities markets are subject to market risks, read all the related documents carefully before investing. Investors are strongly encouraged to carefully read the risk disclosure documents prior to participating in market-related investments or trading activities. Due to the volatile nature of financial markets, no guarantees can be made regarding investment returns. Motilal Oswal Financial Services Ltd. does not offer any assured returns on market-linked securities. Please note that past performance of stocks or indices is not indicative of future results.
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