Caught in global maelstrom, rupee, govt bonds likely to weaken further

The key factors that have wreaked havoc on fixed-income and currency markets are the Russian invasion of Ukraine and the US Fed's decision to embark upon the most aggressive monetary tightening cycle

Indian government bonds and the rupee are likely to weaken in the year ahead as a series of adverse global developments has led to a rapid tightening of financial conditions, even as the sustainability of domestic growth recovery remains to be seen.

At the end of Samvat 2078, the yield on the 10-year benchmark government bond had climbed a massive 126 basis points (bps), reflecting the significant degree of monetary policy tightening carried out by the Reserve Bank of India (RBI) in the face of persistent inflationary pressure.

Bond prices and yields move inversely. The rupee has shed 10 per cent against the US dollar over the same period, marking the worst performance for the Indian currency in a Samvat year (since 2074).

The two key factors that have wreaked havoc on the fixed-income and currency markets are the Russian invasion of Ukraine and the US Federal Reserve’s (Fed’s) decision to embark upon the most aggressive monetary tightening cycle in nearly two decades.

Both events have worsened the outlook on India’s inflation, which has remained above the RBI’s 4 per cent threshold for three years. The war in Europe has led to a sharp rise in global commodity prices. Meanwhile, the weakness in the rupee, caused by the global rush towards the dollar amid higher US interest rates, has made imports more expensive.

The global growth shocks have also clouded the outlook on India’s growth, with several international agencies, as well as the RBI, reducing forecasts for gross domestic product (GDP) growth.

This does not bode well for the rupee as the appeal of Indian assets to overseas investors primarily comes from the country’s growth prospects.

“On growth, as the global slowdown materialises and remains entrenched, pent-up demand fades and financial conditions tighten, we expect GDP growth to slow from 7.2 per cent year-on-year in 2022 to a below-consensus 4.7 per cent in 2023,” wrote economists from Nomura earlier this month.

Moreover, the Fed is not seen slackening its pace on rate hikes.

“Given the strength of the (US) economy, we suspect the Fed may have to hike policy rates higher than its indicated peak levels of 4.6 per cent,” wrote economists from IDFC Bank.

“Domestically, we expect the terminal repo rate to reach 6.75 per cent, which implies that the interest rate differential between the two countries will continue to narrow. This supports continued depreciation pressure on the rupee,” they wrote.

On Friday, the rupee closed at 82.69 per dollar.

Government bonds, which, over the past few years, were the beneficiaries of an immense surplus of liquidity in the banking system and record-low interest rates, now find themselves faced with exactly the opposite scenario.

The liquidity surplus has shrunk rapidly and is now heading towards a deficit, while the RBI has raised interest rates by 190 bps since May. The central bank is expected to hike the repo rate further from its current levels of 5.9 per cent.

Until the volatility in the exchange rate subsides, it will be difficult for the RBI to infuse liquidity into the banking system, implying that for now, government bonds cannot rely on the central bank for support.

IDFC First Bank expects the 10-year bond yield to rise to 7.75 per cent, from its current levels of 7.51 per cent.

Amid unfavourable factors, a saving grace for both bonds and the rupee would be the much-awaited inclusion of sovereign debt in the global index.

Major index providers have indicated that the process could occur in the next calendar year. Such a step could bring in about $30 billion of foreign flows into bonds over a year, helping the government finance fiscal deficit, as well as ease the stress on the rupee.

Another potential source of support for the bond market is the possibility of the RBI choosing to infuse liquidity through sovereign debt purchases some time in 2023 as credit growth booms and liquidity shrinks further.

The central bank has maintained it is ready to provide liquidity for the productive sectors of the economy.