India’s benchmark bond yield does not reflect slowdown

The Reserve Bank of India may have surprised the market by its sudden decision to purchase Rs 10,000 crore of the 10-year government benchmark bonds and sell an equal amount of short term securities through an auction on Monday. But, the country’s sovereign bonds had a problem. Quite like the stock market, they too were not reflecting the true state of the economy.

The hardening of yield on 10-year benchmark bonds for some time and, the upward shift in the yield curve -- the gap between the rate of interest on shorter and longer-term bonds – suggested revival in the overall economy. It also indicated financial markets expecting future interest rates to go up sharply. Both are not true in the Indian context at present.

It is the 10-year G-sec paper, which mainly determines the rate of interest banks charge from borrowers. When an economy is stagnant or slowing down, the yield curve should rather be flat, suggesting no difference between short and long term securities of similar nature.

The yields on domestic bonds did not mirror that, of late. The gap between yields of short (one-year) and long tenor (10-year) bonds remained close to 1.5 percentage points or the highest compared to other Asian peers or even the developed market. In the US, the gap is close to a quarter percentage points.

The interest rate on debt paper of 2029 maturity yielded 7.42% on January one. However, the RBI’s move to lower interest rates since February this year kept providing an occasional softening bias to the yields. The central bank has cut the repo rate by 135 basis points since February and has remained ahead of most of its global peers in the current easing cycle.

The yield on 10-year benchmark 2029 bond did not reflect the effect of monetary easing and remained in the range of 6.60%and 6.75%. On December 5, however, they rose above the psychological 6.80% mark, soon after the RBI announced a pause on the policy rates. This created a gap between the RBI’s repo rate of 5.15% and the yield on the 10-year benchmark paper of 165 bps.

This also marked an abnormally high spread or difference between the rate of return between these two investments. Usually, the spread is less than 50 bps when the central bank’s policy stance is accommodative. Why did the benchmark yield rise so much and why the yield curve became steeper? The RBI had not signalled a change in its stance. It remained accommodative. The curve also moves upward when the market senses a larger than expected fiscal slippage and a bigger than expected borrowing from the government. Whatever may be the reason, the RBI appears to have sensed the government’s forthcoming moves and the consequent mood of the market.

And, that is the reason, it may have taken an unconventional step of buying the long term securities to bring the interest rates down on such papers, which can naturally boost the economy when the conventional repo rate cut does not act as prescribed.

The 10-year bond yield is the benchmark for interest rates on all fixed-rate loans. These include loans for home, auto and other consumer durables. Lower fixed rates will allow these businesses to expand at a lower cost and also result in economic expansion.

On the contrary, a higher hits transmission of rate cuts by the central bank makes borrowings by the government costlier. Besides, companies borrowing through bonds, also have to pay more. Not only that, but the rise in yields also hit bond portfolio of bank treasuries. There is less return on bonds as yields rise, prices of bonds fall.

RBI Governor Shaktikanta Das had made it clear on the day of the monetary policy that even after a huge 135 bps cut, the transmission to the government securities market, had been partial at 113 bps on 5-year government securities. And a whoppingly pessimistic 89 bps on 10-year government securities. He had given an indication that the conventional tools had not been working optimally.

So, a mild twist in monetary tools came late last week aimed at putting downward pressure on longer-term interest rates. The yield on the 2029 debt fell as much as 16 basis points to 6.59% after the RBI announced special OMO on Thursday. That was the steepest fall in the 1-year benchmark paper, making it Asia’s top performer.

Lower interest rates on benchmark securities will make the government borrowings cheaper. The government is expected to borrow more in the next fiscal year – 2020-21 because the fiscal slippage is expected to be higher than expected this year. Unless the yields start trending down, the borrowing cost for the sovereign will rise again.

In the current fiscal too, the government had announced a record high borrowing of Rs 7.1 lakh crore but the RBI supported it by doing open market operations of close to Rs 3 lakh crore. That was aided by a surplus capital transfer of Rs 1.76 lakh crore to the government. Next year, the twist in monetary tool might help. Some economists have, however, chosen to liken the RBI’s move with ‘Operation Twist’ of the US Federal Reserve, which had been invoked twice in that country. The first time, in 1961, when its economy went into a recession and after that in 2011-12, when Fed chair Ben Bernanke sought to make long term borrowing cheaper through quantitative easing and prodded banks to do aggressive lending to stem the American slowdown.

Is the RBI too, smelling a bigger slowdown in the Indian economy?