Bond Yields Spike To Above 7%. Here’s Why.

India’s benchmark 10-year bond yield crossed the 7 percent mark on Tuesday, scaling its highest levels since September 2016. Bond yields moved higher following inflation data which showed that price pressures, at the retail and wholesale level, are rising in India. Both retail and wholesale inflation were at 3.6 percent in October, shows data released by the government this week.

Bond yields, however, had been rising even before the inflation data. Concerns over the government’s finances, tightening liquidity conditions, continuing bond sales from the central bank and, now, higher oil prices are some of the factors that are pushing up benchmark interest rates.

A Perfect Storm For Bonds

Bond yields have been moving higher since July when concerns on government finances cropped up. The central government front loaded its spending this year but indirect tax collections have turned uncertain after the implementation of the Goods and Services Tax. While the government has not given any indication that it would breach its fiscal deficit target of 3.2 percent of GDP, some in the markets fear that meeting the target would be a tough ask. Nomura Global Markets Research is penciling in a higher fiscal deficit of 3.5 percent of GDP for the year.

The fear of a higher deficit, and consequently higher central government borrowings, coincided with the end of a period of ultra-low inflation in India. Both retail and wholesale inflation, while still moderate, are moving closer to the central bank’s medium term target of 4 percent.

Market participants have also expressed concern about continuing bond sales from the central bank under its open market operations (OMO) facility. While liquidity conditions have tightened, the central bank has continued with its bond sales. Unless the central bank changes its stance, rating agency ICRA believes that the benchmark 10-year bond yield may trade about

Rising oil prices is the most recent worry for bond markets. Higher oil prices will feed into inflation and also pressure the twin deficits (current account deficit and fiscal deficit) as India is a net importer of oil and still subsidies some oil products.

Changing Global Scenario

The global scenario has changed too. In the US, the benchmark 10-year yield has been trading close to 2.40 percent. Short term yields have also risen and the yield curve has flattened. Higher yields on lower risk instruments in developed markets reduce appetite for higher risk emerging bonds.

Vivek Rajpal, India Rates Strategist at Nomura also pointed out that investors are anticipating a turn in the monetary policy scenario in emerging markets. With inflation and oil prices on the rise, the expectation is that most of these markets would move into a period of steady or rising interest rates.

Both these factors could lead to reduced foreign investor interest in Indian bonds. Data from the National Securities Depository Ltd. shows that foreign investors have been net sellers of Indian bonds to the tune of Rs 1000 crore so far this month. This is the first month since January, that foreign investors have been net seller in the Indian bond markets.

Have Rates Bottomed Out?

Rising bond yields point to the bottom of the rate cycle in India. Some economists still expect one last rate cut from the RBI but most expect a prolonged pause in policy rates.

Bank of America-Merrill Lynch is among the minority that expects a rate cut in the December policy. “On our part, we continue to expect the RBI MPC to cut on December 6 to signal a bank lending rate cut, before the 'busy' October-March industrial season intensifies, to support recovery,” wrote Indranil Sen Gupta, India Economist at the research house in a note on Tuesday.

DK Joshi, chief economist at Crisil, however, feels expects a rate cut only if second quarter GDP data disappoints. The data released is scheduled for November 30. “If the downside risks to growth rise, and inflation materially undershoots the Monetary Policy Committee’s forecast, only then there is a possibility of a rate cut,” wrote Joshi.

Even if the RBI were to cut rates one last time, banks may hesitate to pass on the lower rates due to tightening liquidity conditions. The headroom for cutting rates seems to be over for now, said Rajneesh Kumar, chairman of State Bank of India last week.