Bond vigilantes stirred by US tax bill cloud foreign inflows to India

The spread between the benchmark 10-year Indian and US bonds has shrunk to a level last seen over two decades ago after the US Tax Bill

Narrowing interest rate spreads between the US and Indian bonds, driven by a slump in the world’s largest bond market, have clouded inflows into the domestic debt market. However, experts see only a minimal impact on Indian equities. 

 

“It’s a rather odd situation,” says Madan Sabnavis, chief economist at Bank of Baroda, describing the current state of the US economy—where bond yields are rising, the dollar is weakening, growth is slowing, inflation is poised to rise, and the Federal Reserve remains on hold.

 

All this as the US House Committee cleared President Donald Trump's 'big, beautiful' tax bill, which threatens to add trillions of dollars in the years ahead to already rising budget deficits. While the stock market remained volatile, the so-called bond vigilantes drove yields on benchmark 30-year treasuries to near a two-decade high of 5.1 per cent.

 

  'Bond vigilantes' are usually investors who dump bonds to pressure governments on fiscal discipline. A rise in yield will make it difficult for the government to repay their borrowings, thereby giving the bond market greater influence over fiscal decisions.

 

In fact, bond markets have steered policies earlier. Donald Trump reversed a tariff decision just 13 hours after it took effect, following a sharp drop in the bond market. Similar episodes occurred in the early Clinton administration in 1993 and across Europe after the financial crisis, according to Bloomberg. 

Debt market impact

 

The spread between the benchmark 10-year Indian and US bonds has shrunk to about 173 basis points, a level last seen over two decades ago, despite domestic yields falling to their lowest in more than three years.

 

Definitely, in terms of the debt market, there will be a slowdown in foreign portfolio investment (FPI) debt flows to emerging markets, including India, Sabnavis said. "This trend is likely to persist for some more time."

 

Global funds have already pulled out ₹4,000 crore from the Indian bond market last week (excluding Friday), the highest in over a month, according to data compiled by Business Standard. This is on account of yields narrowing between the two countries, experts said.

 

As spreads are falling, foreign investors might see value in investing in their home country rather than in Indian bonds and reducing country risk and currency risk with that trade, according to Aamar Deo Singh, senior VP Research at Angel One.

 

Rising yields in the US are always seen as a headwind for Indian markets as liquidity gets squeezed out of the markets, he said. "If US Yields continue to rise or the spreads continue to remain at a 20-year low, there is a high possibility of money continuing to flow out of India," Singh added.

 

Given the narrowing yields in the medium, experts advise investors to adopt a cautious approach and focus on diversification into various asset classes. A surge in US yields clearly indicates a flight towards safer asset classes, Singh said. "As far as India is concerned, the RBI has a close watch on the economic developments across the globe, and will act as and when required, keeping in view India's overall economic scenario." 

Minimal impact on equities

 

However, equity markets are unlikely to face the heat as experts say that the US debt markets are fundamentally different from the capital that comes to Indian equities. "No one can claim there is zero impact, but it's minimal," according to G Chokkalingam, founder of Equinomics Research.

 

FPI inflows into domestic equities did remain volatile in the last week, leading to the highest weekly outflows since the second week of April. Global funds pulled out stocks worth ₹12,267.7 crore in the week gone by, not including Friday's session.

 

There may be some overlap, but broadly, the money flowing into Indian equities is typically allocated for equity specifically, not debt, Chokkalingam said. "The best example is this—despite a 500 basis point increase in US interest rates (from 0.25 per cent to 5.25 per cent), there wasn’t a large-scale exit from Indian equities. If there were a strong bond yield impact, the capital should have moved back to the US long ago—but it didn’t."

 

Typically, equity and debt investors belong to different firms, and a switch from debt to equity may happen at the margin, but not significantly, Sabnavis said, echoing Chokkalingam's views.