As bond yields rise in the US, RBI under pressure to raise rates in India

The central bank will have to raise rates to maintain the spread between the bond yield in India and US

The yield on 10-year US government bonds have risen to two-year highs and are just shy of the 3% mark as investors worry about a likely withdrawal of monetary stimulus by the Federal Reserve.

Including the 5 basis point rise on Friday, bond yields in US are now up 131 basis points from their lows in May this year. Yields refer to the interest income that a bond holder receives if they buy it at current price and hold it to maturity.

Experts say that this will put pressure on the Reserve Bank of India to raise interest rates so as to maintain the spread between the bond yield in India and US. The yield spread –the difference in the interest rate that a Indian bond pays over US government bond – has narrowed in recent weeks as yields in India have failed to keep pace with the rise in US.

Bond yield in India are up 68 points since May this year, less than half the rise in US. The spread declined to 546 points on Friday from a high of 636 points reached in middle of last month and over 600 basis points at the beginning of May this year. 100 basis points or bips makes a per cent.

There is scope for a further rise in bond yield in US as the date for stimulus withdrawal gets closer. In last ten years, the median yield on a 10 year bond in US is 3.78% while average yield has been 3.55% during the period.

“The rise in bond yield in US is an indication that interest rates are rising globally and it is here to stay. Ultimately it will get transmitted to India either through imported inflation from higher energy and commodity prices or through higher cost of foreign capital,” says Deep Narayan Mukherjee, director Ratings at India Ratings, the domestic credit rating arm of global rating agency Fitch.

It may some take time for the central bank to raise the benchmark interest rates in response but it will start showing up in the real economy much sooner, he says.

Analysts agree. “We can’t have a situation where bond yield or the interest rate in US keeps rising while that in India remains flat or falls. We expect interest rates to harden further in India in line with the global trend,” says Dhananjay Sinha, co-head institutional equity at Emkay Global Services. If the Reserve bank of India drags its feet on raising benchmark rates, the transmission will happen through currency depreciation, he says.

Experts say that the central bank also has to be mindful of elevated level of inflation in India while taking a stance on the interest rate.

“A persistently high level of consumer inflation meant that interest rates have been negative for most of the last five years. This is unsustainable and should correct soon,” says Mukherjee.

Some disagree and say that a lot depends on the upcoming meeting of Federal Reserve open market meeting slated for 18th of this month.

“There is lot of uncertainty in the global markets right now regarding Fed monetary stance. This is causing market volatility making it tough for policy makers in emerging markets,” says Arun Kumar R, vice-president, India Credit, Nomura.