10-year G-Sec, repo spread reaches decadal high; market expects inflation

The spread between the benchmark 10-year government bond’s yield and the Reserve Bank of India’s policy or repurchase rate (repo) is now at the highest in more than a decade, suggesting that the market expects a much higher interest rate and inflation in the coming months.

The yield on the 10-year government security (G-Sec) settled at 6.35 per cent on Wednesday, 235 basis points (bps) higher than the RBI’s repo rate of 4 per cent.

The current differential or spread is nearly three times the average spread in the last 10 years. The median spread has been around 88 bps since the beginning of calendar year 2012 (CY12).

A steady rise in the spread also means that the actual borrowing cost for firms and the government is much higher than what the RBI would prefer it to be. The benchmark bond yield has risen 59 bps since May 2020, while the RBI has kept its policy rate unchanged at 4 per cent.

The rise in the spread is, however, not a recent phenomenon. It has hovered above 1 per cent or 100 bps for the better part of the last four years as the RBI has tried to boost economic growth by lowering borrowing costs.

This analysis is based on month-end data for the yield on 10-year G-Sec and the RBI’s repo rate.
 

“The RBI’s reluctance to raise the repo rate means that the short-term interest rate and the bond yield may continue to inch higher even if the repo rate stays anchored to the current level,” says Dhananjay Sinha, managing director and chief strategist at JM Institutional Equity.

Economists say a steady rise in the spread suggests that the markets expect interest rates to rise. “The bond market participants look at the macroeconomic picture differently from the RBI. They expect interest to be much higher in future given large borrowings by the central and the state governments,” says Madan Sabnavis, chief economist at CARE Ratings.

India’s wholesale price index (WPI)-based inflation is currently at a record high 12.5 per cent, while the overall consumer price index (CPI)-based inflation has cooled a bit in the last few months, though it is on the higher side of RBI’s tolerance range.

The International Monetary Fund (IMF) expects India’s total public debt — the combined borrowing of central and state governments — to reach a record high of around 91 per cent of country’s gross domestic product (GDP) in financial year 2021-22 (FY22).

Analysts say the RBI is currently focussed on pushing-up India’s GDP growth and is not too concerned about other macroeconomic factors such inflation and higher public debt.

This, however, risks putting the RBI behind the curve and raises a question mark over the effectiveness of its monetary policy.

“We must admit that maybe for the first time since 2019, the thought occurs that the RBI may be missing a trick,” writes Suyash Choudhary, head of fixed income at IDFC Mutual Fund.

The central bank’s singular focus on economic recovery from the Covid-19 shock is fraught with significant risks, and has the potential to render the environment more volatile which, ironically, can further delay recovery, according to Choudhary.