Sharp drop in India-US 10-year bond yield spread in the past 4 years

Yield spread low despite rise in retail inflation in India

The post-pandemic monetary tightening across the globe has resulted in a lower rise in interest rates in India compared with the United States, resulting in a sharp decline in the spread between the Indian and the US 10-year treasury bond yields in the last four years.

 

The spread has now shrunk to around 255 basis points or 2.55 per cent, nearly 45 per cent lower than 10-year average yield spread of 4.52 per cent. The current spread is, however, 13 basis points higher than the 18-year low spread of 2.42 per cent in October last year.

 

The yield on India's 10-year government bond is up just 28 basis points in the last three years from 6.45 per cent at the end of December 2021 to 6.74 per cent on Friday. In the same period, the yield on US 10-year treasury bonds is up 268 basis points from 1.51 per cent at the end of December 2021 to 4.19 per cent currently. 

   

Such a sharp compression in yield spread last occurred between November 2000 and May 2004 when it declined from 6 per cent to 0.64 per cent. It was followed by a steady expansion in the spreads for the next eight years before peaking at 6.78 per cent in July 2012. In the last 20 years, the spread has been 4.54 per cent on average, significantly higher than the current spreads.

 

The yield spread remains low despite a rise in retail inflation in India in recent months. The retail inflation in India as measured by the consumer price index (CPI) accelerated to 6.21 per cent during October this year from a 5-year low of 3.6 per cent in July this year. In comparison, the CPI in the United States was 2.6 per cent during October, marginally up from a low of 2.4 per cent in September but well below the post-pandemic average inflation rate of 5 per cent. As a result, the retail inflation in India is now running higher than in the US. India's retail inflation in October was higher than in the US by 361 basis points, up from a gap of 167 basis points in October last year and the highest in the last 15 months.

 

Historically, there is a positive correlation between the gap in the retail inflation in India and the US and the spread on the India 10-year and US 10-year treasury bonds. In other words, the higher the retail inflation in India compared to the US, the higher is the bond yield or interest rate in India relative to the US.

 

The correlation has, however, weakened in recent years and spreads have remained low, despite a rise in retail inflation in India.

 

Analysts attribute this to an active management of the bond market by the Reserve Bank of India (RBI).

 

“The RBI has been managing the long and short end of the yield curve by buying government bonds and thus keeping the yields at relatively low levels. We have to see how long it lasts, given the steady depreciation in the rupee,” says Dhananjay Sinha, co-head research and equity strategy Systematix Institutional Equity.

 

This hints at a rise in the yield spread in the coming months if the retail inflation in India continues to remain high compared to its level in the United States. This could also explain the RBI’s reluctance to cut its policy interest rate, despite a slowdown in India’s economic growth in the second quarter of FY25.