Following in the footsteps of the European Central Bank and the US Federal Reserve, the RBI is widely expected to kick-start a tightening cycle in the October MPC meeting. Or at least, the market is quite certain the easing cycle is ending, given stronger-than-expected economic growth on one hand, and looming inflation risks on the other.
A monetary tightening mood has officially set in. The market has already priced it in because the inflation risk is real. In its latest bulletin, released last week, RBI says the escalation of West Asia conflicts has resulted in a sharp increase in oil prices, which reignited fears of a build-up of inflationary pressure. “India’s financial and external sectors are drawing strength from the real economy although geopolitical tensions and weather-related uncertainties are acting as key downside risks,” says the central bank’s ‘State of the Economy’ report. Further, it admits that the rise in sovereign yields in some of the major advanced economies has put pressure on government finances.
Precisely, the elevated US bond yield is the game changer. All major central banks have to reckon with it. A higher risk-free rate in the US is certainly a major attraction for global investors. It acts as an assured return or a reference rate while calculating where to put their money. The emerging markets, including India, have to offer a higher yield to lure global capital from the ultra-safe assets like US Treasuries. Thus, it seems, a monetary tightening is quite likely as the markets have to keep a healthy yield spread.
Notably, markets have unique ways to maintain this spread. Amid the rate hike speculations, India’s bond yield reached a four-month high last week. On September 25, benchmark 10-year bond yield closed at 7.1194%, much above the August average of 6.8-6.9%. It is mainly due to inflation concerns and escalating geopolitical conflicts. A few other factors also favoured this yield surge. First, the US 10-year Treasury yield climbed to an intraday high of 5.20% on September 24 -- its highest level since 2007 -- which could have a cascading effect on emerging-market bond yields.
Second, Brent crude price crossed the $100-a-barrel level due to the escalating West Asia conflicts and supply-chain disruptions. It triggered serious concerns of imported inflation in India. In addition, retail inflation in August hit 4.82%, which prompted the market to aggressively price in a potential rate hike. Above all, the RBI has mopped up excess liquidity from the banking system through the Open Market Operations (OMO). If liquidity in the banking system dries up, yields are likely to soar.
Domestic inflation, economic growth outlook, fiscal prudence, timing of RBI auction, and domestic demand largely determine India’s bond yields. When the tightening starts, the market is likely to demand a higher return on new government bonds (G-Secs). The cost of refinancing existing debt and future borrowings will also surge. Naturally, the higher cost of government borrowings will enforce a high premium on corporate bonds.
So, looking ahead, elevated bond yields are a reality, and the returns on all fixed-income securities in the domestic market will be recalibrated and readjusted based on these new benchmarks. Probably, the biggest gainer may be the rupee. As the central bank raises the policy rate, the rupee may get a breather as monetary tightening can support the local currency by bringing foreign capital into government securities.
For markets, the cheap money flow is ending. Indian equities and bonds must offer higher returns and yields to win back global investors, as these assets are susceptible to emerging-market risk. For India Inc., the current global scenario is a double whammy. Higher crude and commodity prices are eroding corporate profits, which ultimately diminish the attractiveness of equities. Further, higher inflation is hitting consumption growth. As a result, like G-Secs, corporate bonds, too, will have to pay a premium to their investors. The best possible solution to this conundrum is to improve profitability and earnings growth.
(Rajkumar Singhal is an MD & CEO at Quest Investment Managers)
