Trend: 10-year gilt at 18-month high as crude rally brings rate hike spectre closer

NEW DELHI: The 10-year benchmark government bond yield rose to its highest level in one-and-a-half years on Wednesday as the relentless rise in global crude oil prices and worries of higher inflation worldwide led to speculation about the Reserve Bank of India tightening monetary policy sooner than later.

At 12:15 hours (IST), yield on the 10-year benchmark 6.10%, 2031 bond was at 6.40 per cent, the highest level for a 10-year paper since April 16, 2020.

Yield on the 10-year paper has climbed 8 basis points since the RBI’s monetary policy statement on October 8, corresponding to a fall in price of roughly 56 paise. Bond prices and yields move inversely.

Brent crude oil prices, the global benchmark, have skyrocketed around 19 per cent since September due to concerns of global demand outstripping supply; a concern that has been amplified by a recent acute shortage of coal and natural gas worldwide.

Brent crude futures for December delivery on the ICE Futures Europe exchange added 0.9 per cent to close at $85.08 per barrel on Tuesday, the highest settlement since October 3, 2018. November futures on the New York Mercantile Exchange closed at an over-seven-year high of $82.96 per barrel, up 0.6 per cent.

For India, this does not bode well. Given that the country is a huge importer of the commodity, the surge in crude oil prices presents significant upside risks to inflation while worsening the outlook on the trade deficit.

The market’s jitters about higher domestic interest rates can be gauged from the fact that government bond yields are where they currently are despite successive sharp declines in Consumer Price Index-based inflation over the last couple of months.

The pitch is all the more queered when one looks at the signals emanating from central banks in advanced economies. The US Federal Reserve has already said that it is likely to start rolling back its massive quantitative easing programme from next month, while the Bank of England earlier this week said that it is considering rate hikes to tame inflationary pressure.

The talk of a tighter monetary policy has pushed yield on the 10-year US Treasury note up by 34 basis points in the space of a month, with yield on the world’s most sough-after fixed income asset last at 1.65 per cent.

This has also had the knock-on effect of leading to the global strengthening of the US dollar over the last month or so, the domestic impact of which can be seen in the 1.2 per cent depreciation of the Indian rupee versus the greenback since the beginning of October.

Higher interest rates in the world’s largest economy, coupled with a tightening of the global liquidity spigot, may result in outflows of overseas investment from the Indian debt market. The rupee’s volatility may also weaken FPI appetite for Indian bonds as a depreciating currency eats into the returns earned by overseas players from these investments.

While the RBI kept interest rates unchanged at its last monetary policy statement and has several times reiterated its commitment to providing all possible support to economic growth, bond traders fear that the central bank will have to scale down accommodation soon, given the global environment of tighter financial conditions.

While the market is split on the timing of a hike in interest rates (beginning with the reverse repo rate which is the current operative policy rate), consensus seems to be building that the RBI cannot continue to maintain a massive surplus of liquidity in the banking system –currently estimated at around Rs 6-7 lakh crore.

The central bank has already given indications that it is unwilling to add more durable liquidity in the banking system by discontinuing its Government Securities Acquisition Programme, but the talk in the market is that going ahead, tougher measures may have to be taken to bring the surplus down.

“The RBI is in a tough spot. The only way to prevent the 10-year from breaching 6.40 per cent is by doing OMOs, but doing OMOs right now is tricky given the liquidity situation. It is possible that RBI is letting yields drift higher because market fundamentals warrant it, but if volatility is to be prevented, then RBI will have to step in. Stop-losses have been triggered at multiple levels,” a senior treasury official with a large foreign bank said.

The RBI is indeed, in a spot. The economy has not sufficiently recovered from the scars of the Covid-19 crisis to afford a sharp rise in borrowing costs. Higher interest rates and consequently higher sovereign yields will lead to a rise in funding costs for all sectors of the economy, right from corporate entities to those seeking home loans.

Just when domestic CPI inflation has been on a downward trajectory, the central bank is faced with what seems to be the perfect storm on the external front.

RBI increasingly comfortable with gilt yields heading higher, says StanChart’s Kulkarni

Over the last year, the Reserve Bank of India has on several occasions spoken about the orderly evolution of the government bond yield curve and has taken several measures to ensure that sovereign borrowing costs do not exhibit a sharp rise amid the Covid-19 crisis. The levels at which the RBI intervened in the market for much of last year –through both outright bond purchases and secondary market interventions — suggested that the central bank was targeting 6 per cent as the yield level for the 10-year benchmark government security.

Now, however, with the process of normalisation of ultra-loose monetary policy starting, the central bank’s tolerance for higher bond yields has gone up and the 10-year bond yield –the benchmark for a host of credit products-could rise to 6.50 per cent in the near term, said Standard Chartered Bank’s Senior Rate Strategist Nagaraj Kulkarni in an interview with The 10-year bond yield settled at 6.33 per cent on Tuesday. Edited excerpts:

The RBI, in its latest policy statement has discontinued its “GSAP” programme for now while signaling a larger quantum of variable rate reverse repo operations. Is this, in your view, a signal that normalization of policy is starting in India?
The RBI has used several tools to counter the impact of the COVID-19 shock on the economy and to support domestic growth. Now, the RBI is unwinding some of these extraordinary measures by withdrawing excess inter-bank liquidity and not committing to government bond purchases in its G-SAP programme. We believe these are signals that policy normalization has started. However, the RBI has maintained the flexibility to renew the support, if such a need arises.

Short-term bond yields did not really rise after the policy statement; is the market a little more confident of the RBI normalizing policy gradually rather than suddenly?
The RBI has been gradual in its approach and has guided the markets very well; for example, it has announced a calendar for liquidity withdrawal (via VRRR). This gradual approach should help market participants adjust their expectations ahead of important announcements, from the MPC, for instance. Indeed, market participants interpreted the higher cut-off in VRRRs since the last week of September as a signal that policy normalization is already underway.

What is the OIS (overnight indexed swap) curve telling us? The 5-year swap is currently around 155 basis points above the repo rate although the one-year swap still remains more or less around 4.06% levels. What would be a good bet for investors in the OIS market?
We think the recent price action in the OIS market is driven by the rise in global commodity prices (specifically crude oil prices) and government bond yields in developed economies (USTs, Gilt yields). The 1Y/5Y segment of the curve is at its steepest level since June 2010. The steepening of the OIS curve indicates market expectations of continued normalization in monetary policy. We expect such steepness to persist until the RBI starts to ramp up its normalization, after which we expect the curve to flatten.

How confident are you of bond index inclusion happening in the current financial year? What order of flows are you expecting if it were to materialize this year? What are the challenges involved in facilitating the process?
Discussions of Indian government bond (IGB) inclusion in some key global bond indices is not new. Once the debt market reforms are complete, global investors usually need a few months to assess the market before recommending inclusion. For inclusion to happen this year, we think the Indian authorities need to speed up the process of easing operational issues faced by investors. Otherwise, IGB inclusion is likely to be delayed beyond the current financial year.

We expect Indian government bonds in the fully accessible route (FAR) category to be considered for inclusion in important global bond indices. If inclusion were to happen, we would expect inflows ranging from USD 35-45bn ($35-45 billion) over the subsequent 12 months.

Index providers have pre-defined criteria for inclusion in their indices. The most important criteria for IGB inclusion specifically are as follows: (1) global investors should be able to access the market without any constraints (quotas); (2) the operational process of investing must be smooth. By introducing the FAR category, the authorities have arguably addressed point 1 above, but global investors are yet to be convinced about point 2. To overcome the operational issues faced by global investors, IGBs investible via FAR may be made eligible for settlement via International Central Securities Depositories, specifically Euroclear. Global investors are familiar with such settlement processes. Although Euroclear settlement is neither a necessary nor sufficient condition for index inclusion, in the case of IGBs, we believe Euroclear settlement will address point 2 above. This should pave the way for index inclusion.

Does the current level of the 10-year benchmark yield adequately factor in the situation on the fiscal/interest rate front? Has the RBI given a tacit acceptance of higher interest rates by permitting it to rise past the 6.30% level (as against the strong central bank intervention seen last year in managing yields).
We think the new equilibrium for 10Y IGB yields is higher than 6.30% – we estimate c.6.50% in the near term. Compared to the recent past, the RBI is increasingly comfortable with IGB yields adjusting higher. We believe this is also part of normalization.

What is your timeline for an eventual rise in interest rates? Where do you see the repo and the reverse repo rate, say, 6 months down the line?
Assuming no further growth shocks, we expect the RBI to raise the reverse repo rate by 40 bps between the December 2021 and February 2022 policy meetings. We expect the repo rate to be hiked from August 2022, though the risk of an earlier hike exists if the growth recovery is faster than expected or inflation defies the MPC’s glide path of a gradual move towards the medium-term target of 4%.