Fresh tussle between RBI, bond market expected ahead of 10-yr paper launch

The tug of war over bond yields that started after the Union Budget, which announced Rs 12.05 trillion government borrowing plan, finally came to an end with the announcement of the bond buying programme, or the government securities acquisition programme (G-SAP) in April as yields of the 10-year benchmark went down below the psychological 6 per cent mark. Now another round of the bout is brewing ahead of the new 10-year paper, expected to be introduced in the market on Friday.

On Tuesday, bond yields rose across the curve - the yield on the 5.63 per cent bond maturing in 2026 jumped 13 bps to 5.89%, while the 6.64% 2035 bond yield rose 8 bps. The benchmark 10-year yield was up 9 bps to 6.18% - its biggest jump in nearly three months. (1 percentage point = 100 bps).

One of the reasons for the spike in yields was that the bond market players were disappointed with the papers selected by the central bank – most of which were illiquid – for the G-SAP auction that was announced on Monday. Some of the bond dealers were expecting RBI to include the 5-year paper.

Bond dealers said the central bank was artificially suppressing the yield of the 10-year bond, which itself has become illiquid with the RBI holding more than 85% of the stock. The 10-year paper is no longer the most traded one – which is unusual.

“The biggest contributor to the souring of market mood was RBI’s announcement of a new 10-yr benchmark paper, to be auctioned on Friday,” said Madhavi Arora, lead economist, Emkay Global.

“The to-be-issued paper is already trading above 6.15%++ in when-issued market, implying that a much higher coupon cut-off is expected on Friday than the current 5.85% -- leading to percolation of pressure across the curve. This depicts the impending market repricing of the benchmark 10-yr paper -- which has been dirty-managed by the RBI so far by being a sole holder of the security making it extremely difficult for fair market price discovery,” she said.

Yields are also responding to the rise in global commodity prices, particularly crude oil prices, as India is a net importer of such commodities.

Consumer price-based inflation – the main yardstick for the central bank for policy making – accelerated 6.3% year-on-year in May, which was the highest in six months. Retail inflation is expected to gain pace further in June – a factor which will be taken into account by the RBI while announcing its next bi-monthly review scheduled 4-6 August.

“We expect the CPI to rise to 6.7% in June, driven by a sharp increase in core inflation, which we forecast will accelerate to 7.0% y/y, a 7-year high,” said Rahul Bajoria, chief India economist, Barclays.

The mandate for the central bank is to keep CPI inflation at 4%, within a range of +/- 2%.

“Given the need to nurture growth, we expect RBI to maintain its accommodative stance, although communicating its tolerance for elevated inflation will remain a challenge,” Bajoria said adding that CPI inflation is projected to average 5.4% in FY21-22, with risks biased to the upside. In the last policy review meeting in June, the monetary policy projected average CPI inflation for the current financial year at 5.1% - revised upward from 5% projected in April.

“..over the medium term if there is one obvious stress point for India’s macros it is the elevated level of general government debt and the higher than usual annual issuances of paper that is likely to be in place for the next few years,” said Suyash Choudhary, head - Fixed Income, IDFC Asset Management Company Limited.

“More specifically, the annual supply of bonds is a worry with respect to the absorptive capacity for duration with local market participants. This imbalance hasn’t been felt so far in this cycle owing to the proactive interventions of the central bank under its financial conditions assessment framework,” Choudhary added.

While the central bank has emphasised on the orderly evolution of the yield curve in its recent commentary, bond dealers said any exit from the current ultra-loose monetary policy will only be gradual and will be contingent on a sustainable economic recovery. Only after such a recovery in sight, the central bank may shift its focus again on inflation, and could allow tighter monetary conditions.

The market expects the bond yields to inch up in the second half of the current financial year though the central bank is likely to allow the increase more in the shorter end than longer end of the yield curve.