The sovereign bond market witnessed a sharp sell-off on Friday as the Reserve Bank of India’s (RBI’s) unequivocal commitment to bringing down inflation came as a surprise to the market, which had pinned its hopes on a softer approach by the central bank.
The yield on the 10-year benchmark 6.54 per cent 2032 paper jumped 14 basis points to close at 7.30 per cent on Friday, marking the sharpest single-day rise since the RBI unexpectedly announced a rate hike on May 4.
Bond prices and yields move inversely. A rise of one basis point in the 10-year bond yield corresponds to a fall of roughly 7 paise in price.
The RBI’s Monetary Policy Committee, on Friday morning, announced a 50-basis-point rise in the repo rate to 5.40 per cent, and reiterated its stance to focus on withdrawal of accommodation. More importantly for the market, the central bank did not lower its inflation forecast of 6.7 per cent for the current financial year, despite acknowledging that there were signs of inflation peaking.
The clear takeaway for the market was that in a global environment rendered extremely volatile by the Ukraine war and the US Federal Reserve’s aggressive policy tightening, the RBI was not going to take its foot off the pedal.
According to treasury officials, the magnitude of impact on the bond market on Friday had been amplified by increased speculation of the RBI signalling a less aggressive path ahead.
From August 1 to August 4, the yield on the 10-year benchmark government bond declined by 17 basis points as a combination of factors, including a technical recession in the US and reports of the RBI leaning towards a softer rate hike path, prompted traders to stock up on bonds.
“There were expectations that the RBI would hint at going slow. The global theme has changed to some extent. Oil prices are down, and US Treasury yields are coming down. Earlier expectations of Fed hikes are coming off a bit,” Shailendra Jhingan, MD and CEO, ICICI Securities Primary Dealership, told Business Standard.
“Against that backdrop, the market felt that the RBI could be a bit dovish but that didn’t happen. The RBI governor was absolutely clear that it’s a volatile environment and it’s very tough for the RBI to give visibility. I guess the market had run ahead of itself and it’s now correcting,” he said.
Jhingan sees the yield on the 10-year bond in the range of 7.30-7.50 per cent in the coming months.
According to Treasury officials, now that the speculative frenzy of a ‘dovish’ RBI has been dispelled, market levels are more aligned with fundamental interest rate expectations. This has broader implications as government bond yields are the benchmarks that determine borrowing costs across the economy.
Tellingly, at the current juncture, traders do not see the 10-year bond yield revisiting the three-year high level of around 7.60 per cent that was touched in mid-June, even as the RBI is likely to raise interest rates further.
At current levels, the spread of nearly 200 basis points that exists between the repo rate and the 10-year bond yield shows that the bond market has already priced in a great deal of policy tightening.
Traders are of the view that as surplus liquidity in the banking system shrinks due to currency leakages during the festive season in the latter part of the calendar year, the RBI may have room to purchase bonds and support the government’s borrowing programme.
The RBI stopped open market purchases of government bonds in October 2021 because such acquisitions lead to durable addition of liquidity in the banking system. However, as the government’s debt manager, there are expectations that the RBI may step in to buy bonds and improve demand-supply dynamics in view of a record-high borrowing programme of Rs 14.3 trillion.
“We firmly believe there will be a fourth buyer in the bond market. That fourth buyer can be FPIs, although it doesn’t look like that at this juncture, unless certain things change dramatically. Otherwise, the RBI needs to be the fourth buyer,” Jayesh Mehta, Bank of America’s India country treasurer, said in an interview with Business Standard last week.