India’s Yield Curve Is All Bent Out Of Shape

A steep yield curve suggests the bond markets fear inflation. A flat one suggests that the economy is unlikely to pick-up much pace. And an inverted one flashes warning signs of impending weakness, perhaps a recession.

But anyone using those tried and tested principles to try and make sense of the yield curve in the Indian markets will come away scratching their heads. A flush of liquidity and interventions from the central bank have distorted yields across the Indian bond markets. To be fair, central banks across the world have stepped up interventions and India is no exception.

Still, it is worth noting the divergent signals emerging from the Indian bond markets.

An Inverted Short-End...

India’s policy benchmark rate is the repo rate, currently set at 4.4 percent. Ideally that should be the floor on interest rates since it is the rate at which you can borrow overnight funds from the central bank. India, however, still has a policy rate corridor. The lower end of that corridor is the reverse repo rate, the rate at which you can park funds with the RBI. This rate is set at 3.75 percent. While this is not officially the policy, markets take it as the benchmark in times of surplus liquidity.

At an auction of short-dated treasury bills on Wednesday, the rates accepted by bidders were not only below the supposed benchmark repo rate but even lower than the reverse repo rate of 3.75 percent.

The 91-day treasury bill was auctioned at 3.72 percent, the 182-day treasury bill was auctioned at 3.65 percent and the 365-day treasury bill was auctioned at 3.73 percent.

What is the signal in this? It could be one of three things – a rapidly weakening economy will prompt the central bank to cut interest rates once again, large amounts of liquidity are being directed towards risk-free government securities due to the prevailing risk aversion, early signs suggest that the central bank is willing to intervene in the primary and secondary markets to keep interest rates low.

So which one is it? The correct answer is....all of the above.

Fears of growth stalling will likely prompt another round of interest rate cuts from India’s Monetary Policy Committee. At the same time, the RBI will likely keep liquidity in ample surplus. However, risk-averse lenders will prefer to park that money in risk-free short term government bonds, where the risk of mark-to-market losses is lower as well.

Finally, RBI data revealed last week that the central bank bought government bonds in the secondary market even outside the announced open market operations. Traders believe these purchases happened in the treasury bill segment, which has emboldened market participants to take increased bets.

...A Steep Long End

Those watching the long end of the yield curve will come away with a very different view of the world.

On a repo rate of 4.4 percent, the five-year yield is at 5.70 percent and the 10-year bond yield is 6.22 percent as of last Wednesday’s close. The 10-year yield is thus a steep 180 basis points above the overnight rate. Traditionally, a spread of about 100 basis points is considered normal.

What is the message here?

It is that the market fears large fiscal slippage from the government, which would lead to increased supply of bonds. Depending on how broader economic conditions evolve, this fiscal expansion could, in turn, be inflationary. Equally, the markets are sending out the message that they are not willing to take what is termed as ‘duration risk’ for fear of sharp swings in interest rates. Banks, despite sitting on large amounts of liquidity, are preferring to hold short term bonds.

“The current constraint is not system liquidity, but the bank’s lack of appetite to take on duration risk,” wrote Sajjid Chinoy, chief India economist at JPMorgan in a recent note. He pointed out that banks are already holding government bonds far in excess of the required amount and fear mark-to-market losses. Chinoy suggested the RBI consider allowing some relief on that front to push up bank demand for longer term bonds. This, he said, is particularly important since large foreign inflows into the Indian debt markets are unlikely in the near-term given global financial conditions.

The implications of this topsy-turvy yield curve extend well beyond the government bond markets. Corporate rates are pegged to government bonds and so you will see a wider spread between short term and long term corporate debt securities.

The result will be that more and more borrowers may pick up funds for the short-term and face more frequent refinancing risk. We saw this play out in the period after demonetisation when the system was flush with liquidity, most of which was deployed in short term commercial paper issued by non-banking financial companies. In fact, many see that as the genesis of the asset liability mismatch that India’s NBFCs faced in 2018.

Equally, a combination of higher term premia (the gap between short term policy rate and long term bond yields) combined with wider credit spreads (the higher rates demanded to compensate for increased corporate credit risk) will mean that market interest rates for corporations will not come down even though the economy is weak and monetary policy is ultra easy. This will narrow options for corporations at a time when Indian banks remain reluctant lenders.

Update: After this article was published, the RBI on Thursday morning announced that it will conduct simultaneous sales and purchases of government securities under its open market operation programme. The central bank will buy Rs 10,000 crore in long term bonds and sell Rs 10,000 crore in short term treasury bills and cash management bills. Such an operation, dubbed as ‘operation twist’ is usually initiated to manage the yield curve. Should the RBI announce a series of such simultaneous sales and purchases, long term rates may fall while short term rates may move back up towards the policy repo rate.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.