With rupee at new low, Indian bonds may be worst hit if recession grips US

US recession risks are reverberating across the emerging Asian debt complex and nowhere is this more apparent than in Indian sovereign bonds.

Rupee debt has proven to be the most sensitive to an inversion of the US curve in the past and this time is unlikely to be different, according to a Bloomberg study which analyzed four episodes dating back to 2005. In each instance, India’s benchmark yields climbed an average 11 basis points in the 10 days before longer-term US rates fell below those on shorter-dated maturities.

The threat of a US downturn is the latest risk confronting Indian bonds after a weakening rupee and accelerating inflation propelled benchmark yields to the highest in over two years in June. A slowdown in the world’s biggest economy may exacerbate the pressure from outflows, after global funds sold the notes for five months through June.

“In India’s case, the sense is that a sharp selloff in rupee bonds will dominate initially -- as the capital outflow reflex imposes dominantly,” said Vishnu Varathan, head of economics and strategy at Mizuho Bank Ltd. in Singapore, referring to a US recession scenario. “Downside risks to EM Asia currencies mean that foreign investor confidence could be sharply declining.”

Indian bonds have declined in tandem with a slide in the rupee. The currency is now hovering close to a record low against the dollar as elevated commodity prices stoke inflation and boost the subsidy bill. The options market is pricing in a 64% chance that the rupee will weaken to 82 per greenback in the next six months from around 79.6 now.

To make matters worse, yields are already facing upward pressure as the government seeks to sell a record Rs 14.3 trillion ($180 billion) of bonds this fiscal year. Investors counting on the central bank’s help in this regard may be disappointed after a report from Citi last week noted that excess liquidity will limit its ability to conduct outright bond purchases. 

There may be little respite for rupee bonds in the near term. Overnight indexed swaps are pricing in another 150 basis points of rate hikes from the Reserve Bank of India over the next 12 months as retail inflation has remained above the central bank’s 2%-6% target for six straight months.

The following table shows the change in 10-year emerging Asia yields to a Treasury curve inversion in four instances since 2005.