India, US 10-year yield spread at its lowest in 12 years, shows data

The benchmark interest in India is now lagging behind the US – the world’s biggest economy - by a wide margin. The yield on the 10-year US Treasury bill is up 90 basis points (bps) since the end of July this year, while it is nearly unchanged during the period. As a result, the yield spread between India and the US 10-year Treasury bills has declined 376 bps - its lowest level since 2010.

The current spread is nearly 142 bps lower than the 10-year average spread of 518 bps, and 66 bps lower than the 20-year average spread of 442.3 bps.

1 bp is one-hundredth of a per cent.

Most of the decline in spreads between India and the US occurred in the past two years as the Reserve Bank of India (RBI) has run an accommodative monetary policy, compared to its peers in the advanced economies.

Analysts say such a low spread raises the risk of a sudden spurt in bond yields in India or a further depreciation in the Indian rupee, or both.

“The current low spreads are not sustainable, given India’s dwindling foreign exchange reserves, persistently high inflation, growing current account deficit (CAD), and monetary tightening by advanced economies,” says Dhananjay Sinha, director and head-research, strategy and economics, Systematix Institutional Equities.

Historically, emerging markets like India have to offer a certain spread over the benchmark interest rate on low risk currency assets such as US dollar, euro, and the Japanese yen to attract capital. This is especially true for India which needs a steady inflow of foreign capital to fund its persistent CAD.

The yield on the 10-year Government of India could rise to as high as 8.73 per cent, from 7.31 per cent on Thursday, if the spreads revert to the 10-year average.

According to Sinha, the RBI will likely need to raise rates to narrow trade deficit and attract capital.

“Since currency depreciation will have a second order impact on inflation, which is already high, the RBI will likely need to continue raising rates to suppress domestic demand, increase domestic savings, attract external capital flows, and narrow trade deficit,” says Sinha.

“The rate hike by the US Federal Reserve (Fed) is not great news. This will put pressure on the RBI to react as well to protect the rupee and avoid financial stress,” says Sonam Srivastava, smallcase manager and founder, Wright Research.

The RBI has fallen behind the US central bank in raising rates in its battle against inflation. The Fed has raised its repo rate by 300 bps in total since the beginning of the current calendar year. By comparison, the RBI has raised its repo rate by 140 bps in total. This has suppressed the spread between the RBI and the Fed’s repo rate to just 215 bps - less than half the pre-Covid differential of 450 bps.

The contraction in the spread between the interest rate in India and the US has begun to put downward pressure on the rupee. The Indian currency has depreciated sharply in the past two days after a rate hike by the Fed sucked in global capital in dollar assets, leading to rise in the dollar and a decline in major currencies.

The Indian currency has depreciated 120 paise, or 1.5 per cent, in the past two days and closed at a new record low on Thursday.

Analysts see further depreciation in the rupee, given the relatively low interest rate and India’s growing trade and current account deficit. This, say analysts, could force the RBI to raise interest rate to stem the depreciation in the rupee.

“This rise in volatility and higher currency depreciation will also add up as reasons for the RBI to raise rates. If the Fed rate is indeed increased to 4.5 per cent or above by mid-2023, and sustained at those levels, it is highly plausible for India’s repo rate to rise to 7.25- 7.5 per cent in the current cycle,” observes Sinha.