ADVERTISEMENT

What’s (Not) Surprising About India’s Steep Yield Curve

Large supply and muted demand will keep long-term yields high, while short-term rates will fall due to RBI rate cuts.

A broker reacts while looking at financial data on computer screens. (Photographer: Luke MacGregor/Bloomberg)
A broker reacts while looking at financial data on computer screens. (Photographer: Luke MacGregor/Bloomberg)

A steeper yield curve, when the gap between interest rates on shorter term securities and longer dated paper rises, is typically a signal that growth in an economy is set to strengthen and inflation is set to rise. At a time growth is moderating and inflation set to stay modest, the yield curve should theoretically be flattening rather than steepening.

The reverse is true for India.

Growth is slowing, inflation expectations have moderated but the yield curve remains steep and some see it getting steeper.

The gap between a short-dated one-year government bond and the new 10-year paper stands at about 80 basis points, wider than the gap of about 30 basis points between these securities in December. The spread between the overnight repo rate of 6.25 percent and the benchmark 10-year bond also remains elevated at more than 100 basis points.

What’s (Not) Surprising About India’s Steep Yield Curve

Flood Of Supply

While there are justifiable concerns about the elevated level of the benchmark 10-year bond yield at a time inflation is modest, this trajectory of market interest rates is not surprising.

Having factored in the possibility of rate cuts, the markets are now focused on the supply-demand dynamics of government bonds, which currently don’t look favorable for a number of reasons.

The market is bracing for a little over Rs 7 lakh crore in gross borrowings from the government when financial year 2019-20 begins in less than a fortnight from now. The government and representatives of the central bank will meet on March 26 to decide the borrowing calendar for the first half of the next fiscal. If they follow the long-term pattern of completing more than half of the borrowings in the first half, then the markets will see over Rs 3.5 lakh crore in fresh borrowings between April and September. To be sure, the government can choose to do what it did last year and not front-load borrowings. If it does, there may be some intermediate relief in the bond markets.

It must be noted that while gross borrowings in the new fiscal will be high, the net borrowings are stable. That’s because large redemptions of government debt will begin starting 2019-20 until 2022-23. In FY20, about Rs 2.36 lakh crore in government bonds are coming up for redemption. Despite the steady net borrowings, the view on long-term government bonds is not positive. On the flip side, short-term bonds are expected to benefit from further monetary policy easing, suggesting that the yield curve may remain steep.

We believe the possibility of further rate cuts rule out bear flattening of the curve as the front-end is likely to stay anchored on monetary policy easing expectations. The longer end of the curve, however, should still be dependent on other factors such as evolving bond supply-demand dynamics and the RBI’s OMO (open market operation) buyback strategy.
Vivek Rajpal, Rates Strategist, Nomura Global Market Research

Dent In Demand

The surge in government bond supply will come alongside reduced demand for these securities—from the central bank and from lenders.

In FY19, the RBI conducted large scale OMOs and absorbed nearly 75 percent of the fresh issuance. No one is clear what the approach to liquidity management in FY20 will be. Should the RBI moderate its pace of government purchases, the assured demand for government securities will reduce. The RBI’s recent decision to infuse liquidity via long-term forex swaps has already prompted analysts to temper their expectation of intervention via bond purchases.

That isn’t the only demand side factor likely to impact bond yields in the new year. Banks, too, are likely to be less attracted to government securities.

Bank credit growth has continued to remain strong at more than 14 percent. This, at a time bank deposit growth remains below 10 percent. The credit-deposit ratio is at a decadal high, according to Edelweiss Research.

Against that backdrop, banks are more likely to sell down on any excess government bond holdings rather than pile up on them. Till last year, government banks which were under prompt corrective action were forced to park surplus deposits in government bonds. With a few of these banks being released from the corrective framework, even that source of demand will reduce.

That leaves foreign investors. The change in expectations ahead of the Indian elections and the high real yield offered by Indian bonds has brought back foreigners to some extent. Foreign portfolio investors have bought Rs 5,425 crore in Indian bonds in March after remaining net sellers in the first two months of the calendar year.

But foreign investors remain relatively marginal players in the Indian bond markets compared to the central bank and domestic banks. As such if the RBI and large lenders remain on the sidelines, the yield curve will remain steep.

Infusion of durable liquidity, unfortunately might mean lower OMO purchases by the RBI in FY20 and could lead to the longer tenor yields moving higher. CPI and WPI inflation looked within manageable limits and without any spiking of food prices (an unlikely event) it is expected that the RBI’s own inflation projections will be undershot by a decent extent. We expect a 25-basis-point cut in the repo rate in April while the markets have probably started to factor in a 50-basis-point cut. Risk-free yield curve in India is thus expected to steepen.
IDFC Economic Research