This year saw substantial volatility in the Indian bond markets. First, a large foreign institutional investor (FII)-buying triggered rally in April followed by an equally swift FII sell-off and outflow on the back of US Federal Reserve Governor's comments on tapering in May. This had a dramatic effect on not only bond yields which moved from a low of 7.11 per cent to 7.99 per cent in these two months, but also on the currency.
This volatility was followed by another round of sharp interest rate movements as the Reserve Bank of India (RBI) put up a strong interest rate defence of the currency and raised the operative rate in the system from 7.25 per cent to 10.25 per cent. Bond prices plummeted and yields went up by 1.7 per cent even as the rupee depreciated by 15 per cent to 68.8 against the dollar.
As global markets slowly digested the fact that tapering was imminent, it allowed room for gradual easing of the operative rate to the current corridor of 7.75 per cent and 8.75 per cent. RBI's build-up of a war chest of $34 billion in forex reserves also added to the stability in domestic markets. The recent US monetary policy decision to actually announce the start of the taper was thus the anti-climax of a market reaction that had started in May. This explains the muted reaction of the Indian bond markets.
With economic growth languishing at 4.8 per cent and retail inflation numbers at a record high of 11.2 per cent, it is clearly a challenging time for monetary policy makers.
RBI Governor Raghuram Rajan has been articulating his discomfort at current levels of inflation. After hiking the repo rate twice in succession, RBI paused in this month's credit policy, to assess the lagged effect of past monetary actions and the disinflationary impact of low growth. The central bank is also wary of reacting to temporary spurts in food inflation and has chosen to wait for further data. Both headline and core inflation prints will, therefore, continue to remain in high focus in determining the path of bond yields. According to our estimates, headline retail and wholesale price inflation is likely to decline in the coming months as food prices ease. However, core retail inflation is expected to remain stable.
In this context, the recommendations of the Monetary Policy Framework Committee will be important in giving guidance to the market on the choice of a suitable nominal policy anchor that will determine central bank action.
The second key determinant of bond prices will be the quantum and duration of supply of bonds. While the finance minister has emphasised that fiscal targets would be met and hence there was a limited concern about extra borrowings, the proposed debt switch is causing some steepening in the yield curve. The possibility that it would be conducted mostly with long-term investors could ease the pressure related to supply of duration.
More importantly, demand on account of RBI's open market operations will be limited as systemic liquidity is likely to remain relatively comfortable owing to the significant flow of non-resident Indian deposits and bank borrowing-related swap flows.
Demand from FIIs for domestic bonds is also muted at this stage and currently only 32 per cent of the limit available to them is utilised.
In conclusion, bonds will continue to trade in a range, while the market absorbs the steady supply. However, RBI's choice of nominal policy anchor and subsequent inflation prints will be a key determinant for that prices in the future.
The author is senior general manager and head, markets group & proprietary trading group, ICICI Bank
This volatility was followed by another round of sharp interest rate movements as the Reserve Bank of India (RBI) put up a strong interest rate defence of the currency and raised the operative rate in the system from 7.25 per cent to 10.25 per cent. Bond prices plummeted and yields went up by 1.7 per cent even as the rupee depreciated by 15 per cent to 68.8 against the dollar.
As global markets slowly digested the fact that tapering was imminent, it allowed room for gradual easing of the operative rate to the current corridor of 7.75 per cent and 8.75 per cent. RBI's build-up of a war chest of $34 billion in forex reserves also added to the stability in domestic markets. The recent US monetary policy decision to actually announce the start of the taper was thus the anti-climax of a market reaction that had started in May. This explains the muted reaction of the Indian bond markets.
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Going ahead, it is largely expected the domestic factors would now play a more dominant role in determining bond yields. The inflation trajectory/resultant monetary policy actions and the demand/supply balance for bonds will be the key drivers of bond prices.
With economic growth languishing at 4.8 per cent and retail inflation numbers at a record high of 11.2 per cent, it is clearly a challenging time for monetary policy makers.
RBI Governor Raghuram Rajan has been articulating his discomfort at current levels of inflation. After hiking the repo rate twice in succession, RBI paused in this month's credit policy, to assess the lagged effect of past monetary actions and the disinflationary impact of low growth. The central bank is also wary of reacting to temporary spurts in food inflation and has chosen to wait for further data. Both headline and core inflation prints will, therefore, continue to remain in high focus in determining the path of bond yields. According to our estimates, headline retail and wholesale price inflation is likely to decline in the coming months as food prices ease. However, core retail inflation is expected to remain stable.
In this context, the recommendations of the Monetary Policy Framework Committee will be important in giving guidance to the market on the choice of a suitable nominal policy anchor that will determine central bank action.
The second key determinant of bond prices will be the quantum and duration of supply of bonds. While the finance minister has emphasised that fiscal targets would be met and hence there was a limited concern about extra borrowings, the proposed debt switch is causing some steepening in the yield curve. The possibility that it would be conducted mostly with long-term investors could ease the pressure related to supply of duration.
More importantly, demand on account of RBI's open market operations will be limited as systemic liquidity is likely to remain relatively comfortable owing to the significant flow of non-resident Indian deposits and bank borrowing-related swap flows.
Demand from FIIs for domestic bonds is also muted at this stage and currently only 32 per cent of the limit available to them is utilised.
In conclusion, bonds will continue to trade in a range, while the market absorbs the steady supply. However, RBI's choice of nominal policy anchor and subsequent inflation prints will be a key determinant for that prices in the future.
The author is senior general manager and head, markets group & proprietary trading group, ICICI Bank