What are the bond markets telling us?

It is likely that the market is anxious about a widening fiscal gap adding to extant inflation pressures bred by both domestic and global factors

John Carville, the lead strategist of the first Bill Clinton presidential campaign, is reported to have claimed, “When I die I want to come back as the bond market because apparently it’s more important than the f***g Pope!” Carville did have a point. The bond market might not have the oomph of the stock-market but it tells us, in one lithe movement of the bond yield, a myriad of things — investor expectations of inflation and growth, the likely monetary policy path of the central bank, evolving liquidity dynamics and the fluctuations in the fiscal balances of the government.

So what’s the Indian bond market indicating? Before answering that a recap of recent events might help. Last month, for the first time in 14 years, the rating agency Moody’s raised India’s sovereign bond rating from Baa3 to Baa2. A sovereign credit rating is an assessment of the level of risk associated with investing in a particular country. Going by the scheme that Moody’s follows, India moved from being lowest in the investment-grade ranking to the second lowest. 

Another big event last month was the cancellation of an open market operation (OMO) of Rs 10,000 crore by the Reserve Bank of India. Since July, the central bank has conducted nine OMOs (bond sales) to drain out Rs 90,000 crore worth of liquidity from the market.

While the 10-year bond yield declined by around 15 basis points — its biggest slide since November 2016 (after the upgrade and OMO cancellation) — the feel good factor lasted just for a day or two. The ‘bears’ didn’t take long to appear back in the market and after the dust had settled, the benchmark 10-year yield rose back to its one year-high of around 7 per cent.

The muted reaction of the bond market to such favourable events suggests that there are risks that worry investors. The rise in international oil prices has stoked concerns about a quicker rise in inflation and dashed hopes for a rate cut from the Reserve Bank of India (RBI). Then, there is the US Fed factor. Globally, bond markets have started factoring in the US Federal Reserve’s hike in its policy or Fed funds rate in December and tightening of global liquidity in the year to come. Also, there are mounting fiscal deficit worries on the domestic front. The government’s PSU re-capitalisation scheme and the likely shortfall in GST collection are among the key factors that pushed bond investors to consider the risk of a fiscal slippage.The government’s fiscal deficit incidentally touched 96 per cent of the full-year estimate at the end of October. 

Thus, if we look at the picture the bond market is painting, it isn’t quite pretty at first glance. The markets clearly don’t like the government reneging on its promise, keeping public indebtedness at its targeted limit even if there is a solid counter-argument that low private demand for debt gives it some wiggle room. It is likely that the market is anxious about a widening fiscal gap adding to extant inflation pressures bred by both domestic (food price increase) and global factors. The fear of retreating capital flow as the Fed balance sheet crunches and the central bank hikes rates is also getting priced in.

The problem is that all this is happening at growth rates that are far from optimal and pandering to the bond markets could bring new problems. Pruning the budget deficit would entail more ruthless cuts in expenditure or an aggressive tax collection drive that could have negative ramifications for growth.

For the near term, the RBI’s middle path of keeping rates on hold (as we expect it to do when it meets for its next monetary policy on December 6) and ensuring that while liquidity is on a steep trend downward, it doesn’t dry up altogether, might get the balance right.

Let’s leave you with a contrarian view. What if the hardness in bond yields is actually an indicator of the prospect of high growth (with the associated prospect of higher credit demand and so forth)? Let’s go a step further, which is that a 7 per cent yield on the 10- year bond is now the critical threshold that separates expectations of accelerating growth from deceleration. Thus, if it crosses 7 per cent, the growth campers should raise a toast. If it slips below, worries of deceleration dominate.

Take your pick!

Abheek Barua is chief economist and Tushar Arora is senior economist, HDFC Bank