As favourable inflation base effect vanishes, bond yields could climb up

CPI data is expected on Monday; There are fears that it could shoot above expectations

Bond yields, which have been stable in recent times, could rise as retail inflation, which, according to the Reserve Bank of India (RBI), is a key indicator for monetary policy formulation, could see an uptick with the base effect turning unfavourable.

Consumer Price Index (CPI)-based inflation data for December 2014 is expected next Monday. Although the bond market has already factored in a rise in the December figure, there are fears it might shoot above expectations.

CPI inflation rose 4.38 per cent year-on-year in November, the slowest pace in data going back to January 2012. The decline was due to cooling international oil prices, domestic prices of fruit and vegetable and a favourable base effect.

“If inflation data is higher than market expectations, rate cuts by RBI could get delayed. A part of rate cut has already been discounted by the market. The market has factored in a 25-basis point rate cut. If rate cuts get delayed, then the yield on the 10-year bond could even go beyond eight per cent by March,” said Anoop Verma, vice-president (treasury), Development Credit Bank.

RBI Governor Raghuram Rajan raised the benchmark repurchase rate thrice from September 2013 to January 2014 and has since kept it steady at eight per cent. In the fifth bi-monthly monetary policy review last month, Rajan had said a change in the monetary policy stance was likely in early 2015 if improvements in inflation and fiscal health continued.

“The market is aware that the base effect will be unfavourable and we could see inflation inch up. Even a marginal increase as compared to what is expected for inflation cannot be ruled out. The retail inflation print for December should be in the vicinity of 5.5 per cent. If inflation comes beyond 5.5 per cent, then yields could inch up by 5-7 basis points from the current levels,” said Lakshmi Iyer, chief investment officer (debt) and head of products at Kotak Mutual Fund.

The yield on the 10-year benchmark bond ended at 7.86 per cent on Wednesday, compared to the previous close of 7.9 per cent.

The next monetary policy review is on February 3, and RBI could maintain a status quo in the repo rate. “I am not expecting a rate cut on February 3. Before RBI goes for a rate cut, they would like to see how the inflation pans out once the favourable base effect vanishes. Besides, RBI would also like to take into account how the fiscal consolidation is happening. So, RBI may wait for the Union Budget,” said Nirakar Pradhan, chief investment officer, Future Generali India Life Insurance.