Emerging markets stare at higher interest rate as bond yields spike in US

The bond yield in the US reached a two-year high on Friday as the market positioned for monetary tightening and an interest hike by the US Federal Reserve (Fed). The yield on the benchmark 10-year US bonds made an intraday high of 1.8 per cent on Friday, while it closed the day at 1.765 per cent - the highest since January 22, 2021. With this, the US bond market has given up all gains it made from the ultra-low interest rate policy initiated by the Fed after the Covid-19 pandemic break-out in early March 2020.

The yield on the 10-year US government bonds rose from 1.51 per cent at the end of trading on December 31, 2020, to an intraday high of 1.8 per cent on Friday. That makes it the second-biggest move in the yield for the first week of the year in two decades.

Analysts expect this upward pressure on bond yields in emerging markets (EMs), such as India, which benefited from a sharp decline in interest rate in the US. The bond yield has declined to an all-time low of 0.5 per cent in early August 2020, lowering bond yield and interest rate across the world.

"The latest statement by the Fed indicates that liquidity will be far lower in 2022 than in the last two years, while bond yields (or interest rates) will be far higher," says Dhananjay Sinha, managing director and chief strategist, JM Institutional Equities.  

The yield on the benchmark Government of India 10-year bond was 6.54 per cent on Friday - 478 basis points (bps) higher than the benchmark yields in the US. In the past 10 years, however, the median spread of India's 10-year yield over the US 10-year has been 521 bps. Analysts say it indicates a further rise in spread.

“I expect spreads to rise to 500 bps and the US 10-year bond yield to rise to around 2.5 per cent by the end of 2022,” adds Sinha.

Others, however, say there is no direct relation between bond yields in the US and India. “Although there is no direct link, higher yields in the US may make it tough for the Reserve Bank of India to maintain its accommodative interest rate policy,” says Madan Sabnavis, chief economist, Bank of Baroda.

The bond yield differential or spread between Indian and US 10-year bonds has been very volatile in the last three years. It had declined to a low of 429 bps in July 2019 and then rocketed to a high of 577 bps in April 2020. However, it crashed to 429 bps in May 2020 as the Fed greatly expanded its bond-buying programme to fight the adverse economic impact of the Covid-19 pandemic.

The Fed expanded its balance sheet by $1,403 billion in the 2021 calendar year and $4,600 billion in total since the beginning of the pandemic in 2020. These additional dollars were used by the Fed to purchase financial assets, such as US government bonds, mortgage-backed securities, and corporate bonds. This greatly expanded liquidity in the financial markets all over the world and led to a big rally in bond prices. Bond yields crashed to record lows by the middle of 2020.

The US central bank now plans to change its policy direction in a bid to fight the surging price inflation in the country. The retail inflation in the US is now at its highest level since the early 1990s.

The Fed at its December-end meeting hinted at plans to dial down its asset purchase programme and start selling down its stockpile of bonds in a bid to shrink its balance sheet that had swelled to $8,765.7 billion at the end of January 5, from $4,183.6 billion at the beginning of the 2020 calendar year.

The Fed also plans to start raising its policy interest rate in March this year and there could be as many as three rate hikes of 25 bps each in 2022.

The monetary tightening by the Fed is likely to keep upward pressure on bond yields first in the US and then in EMs, such as India, that rely on dollar-denominated capital inflows to finance their current account deficit.