R Ravimohan:Bonds and banks

The Bond Street has been very nervous for the past month. Interest yields rose quite sharply, not entirely unanticipated, submerging most trading books in a sea of red.

While most traders were busy sobbing on each other's shoulders, a smart rally in the bonds caught most of them napping, as yields fell more suddenly than they rose.

Both movements need explanation, especially as the larger market where interest rates are set, namely the banking market, remained entirely aloof from these interest movements.

The questions that need to be answered are a) what drove the interest rate movements? b) what, if any, correlation exists between bond market and the bank market? and c) what, if any, arbitrage opportunities exist between the bond and the bank markets?

Interest yields could go up for a variety of reasons. The most potent driver of the bond market is its expectation of the RBI's policy stance and market operations.

The markets also gyrate to the beat of inflation, liquidity, and global interest rates, as reflected by the interest rates in the US. If they rise, the expectation is that Indian interest rates will also rise.

Admittedly, inflationary pressures and the hike in US interest rates set the stage for a rise in yields in the Indian markets early June.

However, given the ample liquidity in the system, and the expectation that the RBI would intervene to check sharp movements in bond yields, most of the market had not anticipated a rise of 120 basis points in yield of 10-year government of India securities, in a matter of two months between June 12 and August 13.

There were neither any interventions nor any signal forthcoming from the RBI during this period.

Since yields had gone up, the price of securities declined sharply during this period, requiring higher provision for mark-to-market losses.

The RBI, on September 2, relaxed the percentage of securities that banks could classify as "held to maturity" (HTM) in their investment books. This allows banks to mark a smaller portion of securities to market, as HTM securities need not be marked to market. This relaxation potentially reduces the losses on the books of banks.

The yields retracted sharply by over 70 basis points in the three-week period between August 13 and September 3. The market's explanation for this rally is that banks will not sell the government securities in panic, and therefore will not cause a continued depression in prices. Simultaneously, the US interest rate hike fear has abated, as the economic recovery there is much weaker than anticipated.

Inflation is also expected to settle down from mid-September onwards, as the base figures for inflation in the previous year had perked up considerably after mid-September. Therefore, greater stability was expected, as liquidity continued to be easy.

This period of honeymoon has been somewhat shattered by the weekend wake-up call sounded by the RBI, which announced a hike in the CRR by 50 basis points in two stages over the next month, and reduced the interest payable on the CRR balance from 6.5 per cent to 3.5 per cent. There has been a hardening of yields back beyond 6.1 per cent in the past few days.

So then what is the moral of this story that has more twists than the average Hitchcockian cinema? The CRR hike could have been driven by the belief that an absorption of excess liquidity might abate inflationary pressures.

This may not happen, especially as inflation appears to be rising because of costs being pushed up across the entire consumption basket, and because of the nebulous connection between the WPI inflation numbers and M3 growth.

However, there is a possibility that inflation numbers may decline optically due to the base effect. In the unexpected scenario of inflation continuing to climb, the RBI has bought itself the flexibility to hike interest rates.

There are two potential downsides to this strategy. One is the squeeze on treasury profits for banks. This is addressed by the part relaxation from mark-to-market provisions, creating head room for banks to ride the interest hike.

Unintentionally, however, this could affect the incipient investment cycle that appears to be just gathering momentum. The RBI, surely, will carefully balance these issues.

There could be unending debate on whether the RBI could have timed these moves better to avoid the seesaw in the yields that the market witnessed.

The moot point however is that there is unwarranted speculation by the market on the RBI's moves, which is causing it more harm than the fundamentals of the market.

Take for instance the interest rates on banks' deposits and advances. There has been no movement whatsoever in these interest rates, right through these three months of extreme volatility in the bond market.

It seems the depositors have no concerns on inflation, US interest rates, or indeed on RBI's interest rate policy! Bankers also seem pretty sanguine on the interest rate on advances, despite a smart pick-up in credit during these months.

Admittedly, traded bonds are much more responsive than loan books and retail depositors to market events. However, the bank market appears far less speculative about the RBI's role than the bond markets, and as a result, seems to benefit much more in terms of stability and returns.

Once more enterprising markets develop, arbitrageurs both from the trading community and the fund industry will design products to take advantage of the seeming contradictions in the interest rates in the bond and the bank markets.

For instance, by constructing an imaginative portfolio of government securities with residual maturity corresponding to different deposit periods, there is a possibility that a large chunk of depositors could be weaned away as these portfolios would fetch higher yields now, given higher yields on government paper than corresponding deposit rates. More enterprising bankers might start pushing interest rates on their advances, alluding to the tightening interest rates on the bond markets.

Savvy tech-jockeys could now construct models that straddle fixed-loan books of banks and floating yields on the bond market and make a clean profit between these spreads.

Or simply, bond traders could derive greater succour from the stable interest rates on the deposit and advances front than in the past.

On its part, the RBI has been valiantly attempting to wean the bond markets off its scent. Its burden would certainly reduce if it succeeds in achieving that remoteness.

It will be greatly helped in this endeavour by a more transparent, screen-based market that reduces collusion amongst players.

The RBI could also take the wind out of the market speculation by being more proactive with its pronouncements and more definitive in administration of its rules, especially prudential norms.

This would reduce expectations that the RBI can be petitioned for relief every time market turns against the banks.

Greater demarcation between real economics and the monetary system would also isolate problems, if any, in their respective spheres, rather than spilling over and causing wider repercussions.