Interest rate cycle is turning, experts foresee gradual rise in loan costs

10-year bond yield may touch 6.5% soon, guided by orderly evolution motif of RBI

The 10-year bond yield may rise to 6.50 per cent soon and touch even 7 per cent in a year, indicating a turn in the rate cycle, which will push up borrowing costs for the government, firms, and retail loan takers. However, the rise will be slow, experts say, and players in the system will have ample time to readjust to it.  

The Reserve Bank of India (RBI) had tried to keep the yield under 6 per cent for the better part of the calendar 2020, but has let it rise gradually since February this year, preferring an “orderly evolution of yield curve”.

A beneficiary in the system would be savers. While inflation averaged 6.6 per cent in calendar 2020 and 6.2 per cent in 2020-21, the SBI one-year deposit yielded 5 per cent or thereabouts. A negative real interest rate the RBI will try to correct, bond dealers say.  

Lower-rated corporate firms, which are most of the rating universe in India, will be the worst hit because they did not have proper access to finance even when liquidity was good. But the better-rated firms will continue to do good because each bank will try to be one jump ahead of others to lend to them, and the markets too will be eager to lap up their bonds.  

The rise in yields will also hit retail borrowers who have linked their loan rates to external rates. But liquidity will still be ample in the system for at least a year.

The yield gradually moved up from below 6 per cent to 6 per cent in February. While it dipped again below 6 per cent in two months, it started inching up following the rise in US bond yields.

The 10-year bond yield closed at 6.36 per cent on Tuesday. Experts say it should rise to 6.50 per cent by the end of December or in January, and the central bank would still be fine with it. “Liquidity has been in abundance in the system, but the surplus creates a bigger role at the shorter end of the yield curve (say, three-month/six-month maturity Treasury Bill) than at the longer end (say, 10-year government security). The market has been apprehending a rate reversal for some time, and today we are at the cusp of it. This plays a bigger role at the 10-year segment," said Joydeep Sen, consultant, fixed income at Philip Capital.

“Rate normalisation is a matter of time, and we can expect initiation in the December 6-8 policy review itself. The RBI will still be supportive and lead the market to a gradual up-move in interest rates,” Sen said.

The bond market is indicating such rate movements much in advance.

“The 10-year yield is heading towards 6.50 per cent, but there is resistance around 6.40 per cent,” said Rahul Singh, fund manager, fixed income, LIC Mutual Fund. 

Singh expects the 10-year yield to touch 7 per cent in about a year, but the journey would be “bumpy”. “The RBI still believes growth indicators have not achieved full capacity but inflation still could be managed,” Singh said.

The core implication of the bond yield movement is that rates are tightening indirectly, without the central bank announcing it.

“The rise in yields is a reflection of changes in the interest rate environment, which includes commodity prices and the growth-inflation outlook. But the RBI is comfortable with orderly movements in yields, which is a kind of silent normalisation -- allowing market-based rates to inch up gradually, without touching policy rates,” said Soumyajit Niyogi, associate director, India Ratings and Research. 

The halting of the assured bond purchase programme by the RBI should be taken as the first step towards policy normalisation, RBI Deputy Governor Michael Patra, who is also in charge of monetary policy in the central bank, and is a member of the six-member monetary policy committee (MPC), had said in the October policy.

A concomitant step is to drain out excess liquidity through the system, done partially by increasing and rolling over the amount through the variable rate reverse repo window.

The RBI is currently in stage two (liquidity tightening) of the four-stage monetary policy normalisation process, said Goldman Sachs in its India 2022 outlook report.