Yield curve steepens, short-term rates drop on RBI rate cut decision

A rate cut by the Reserve Bank of India (RBI) has brought down short-term rates, but longer tenure rates are refusing to come down as supply in that segment has satiated market appetite.
 
This behaviour of the rates meant that the yield curve has steepened with shorter term rates falling faster than longer term rates. Longer term rates, in fact, have inched up a little after the rate cut.
 
The RBI announced its rates decision on February 7, where it cut policy rate by 25 basis points and indicated more rate cuts for the coming days.
 
On February 7 closing to now, the 10-year bond yields have moved up from 7.32 per cent to 7.36 per cent. However, the 5-year bond yield has moved down from 7.21 per cent to 7.15 per cent, three years from 7.05 to 6.99 per cent, and one year from 6.66 per cent to 6.64 per cent.
 
A steepened yield curve is a good indicator, but all segments should move in the same direction, based on the tenure of the movement. But the curve steepening due to one segment falling and the other steepening gives conflicting signals.
 
The lower short-term rates may reflect liquidity infusion by the central bank as well as expectation of future rate cuts. However, the longer rates staying firm may indicate inflation has bottomed out and rates need to remain firm, according to Soumyajit Niyogi, associate director, India Ratings and Research.
 

The longer term rates also remain high because of oversupply of papers in that segment, according to Ramkamal Samanta, vice-president, investment, Star Union Dai-Ichi Insurance.
 
“There are two competing forces at play. The dovish stance from the RBI is leading markets to believe that there could be at least one more rate cut after this one, whereas the Budget indicates a large supply of bonds the market will have to absorb,” said Suyash Choudhary, head of fixed income at IDFC MF.
 
“Given this backdrop, the two-five-year AAA bonds look favourably placed. The yield curve could steepen as the short- to medium-end of the curve remains well anchored with benign monetary expectations while supply pressures are felt on the longer-end,” Choudhary told Business Standard.
 
Extra borrowing of Rs 36,000 crore in the 2018-19 financial year (FY19) and gross borrowings of Rs 7.1 trillion next year would lead to the large supply of government bonds in the market.
 
“Going forward, we expect the short and medium-term rates to come down by 25-35 basis points and the long-end rates to be range-bound due to supply pressures,” said Murthy Nagarajan, head of fixed income, Tata MF.

 
The dynamics also play out differently for the mutual fund industry.
 
“Given the higher yields that remained in the short end after the liquidity crisis, the scope for shorter rates to ease is higher. Essentially, ultra-short, term short-term or medium term accrual funds that held short to medium corporate bonds may see a short rally. For dynamic bond and gilt category, the low returns in the past year may be normalised if the rate cut phase continues this year. This will help investors regain what they lost,” said Vidya Bala, head of mutual fund research, FundsIndia.com.
 
Finally, the increase in cash in circulation holds importance for the system liquidity and the RBI’s intention to do secondary market bond purchases. This again influences how the yield curve behaves.
 
Currency in circulation surged to Rs 20.65 trillion on January 18, higher than the pre-demonetisation level of Rs 17.97 trillion. This surge in cash in circulation could be the result of recovery in the informal sector, economists pointed out.
 
However, this is leakage from the system, which, coupled with the RBI’s dollar sales in the market, dries up the system. This partly explains why the RBI is expected to purchase bonds worth a record Rs 2.7 trillion from the secondary market.
 
HSBC expects the Reserve Bank’s secondary market bond purchase in the next fiscal to remain contained at Rs 1.8-Rs 2 trillion range.
 
The relatively less bond market support, alongside heavy supply in the long-term supply may push up longer term rates even further. But, shorter term rates too should go up as the RBI won’t have much room to cut rates in the next financial year, say bond dealers.
 
The rise in yields, therefore, should be in tandem and not opposite each other.