Why bonds dealers chose to ignore Shaktikanta Das' nationalist call

There's a tug-of-war between the RBI and the bond market, as the central bank refuses to accept higher yields

The Reserve Bank of India (RBI), the merchant banker to the government, is required to borrow Rs 2.16 trillion from the market in February and March by auctioning government securities. The number goes up to Rs 4.5 trillion if state development loans are also included.

In such a scenario, the RBI decided to cancel the auction of two government securities totalling Rs 22,000 crore on Friday – the day it announced the outcome of its monetary policy review. Two other papers were devolved on primary dealers.

The auctions were cancelled because the central bank was not comfortable with the higher yields that the bond dealers were demanding. Yields and bond prices move in opposite directions. Since there will be a supply glut, prices should be lowered. And that is why the bond market demanded higher yields.

Cancelling bond auctions is not new. RBI has done it earlier, too. However, since this is February, there is not much time to complete the borrowing requirements. And not to forgot, loan demand is much higher in March, thanks to a demand from banks trying to beef up their balance sheets and meet targets – a year-end phenomenon. So, the price of money next month will be much higher than it is now. The government’s borrowing is typically completed by early- or mid-February. But this year is an unusual one because of the coronavirus pandemic, which has seen the government borrowing a whopping Rs 12.05 trillion. Its gross borrowing in 2019-20 was Rs 7.1 trillion.

What is intriguing is that the bond auction was cancelled on a day when the policy review was being announced. There was a demand from bond dealers for a calendar of the RBI’s open-market purchase of bonds; that did not materialise.

A section of market participants also expected a rate cut, though a majority expected the status quo. The disappointment partially reflected in the spike in bond yields after the policy announcement which prompted the central bank to buy bonds from the secondary market to cool yields, traders said.

The policy statement did not meet the demand of the bond market which led to a rise in yields. Instead, the governor made a clarion call to the bond market, for a second time in six months, stoking a nationalist sentiment by saying the yield curve was a public good.

“In addressing the discomfort of markets regarding persistently higher inflation prints and the large supply of government paper, the maintenance of financial stability and the orderly evolution of the yield curve were explicitly regarded as public good as the benefits accrued to all stakeholders in the economy,” the governor said. He later defended this in the post-policy media interaction by saying government bond yields acted as a benchmark for several other bond prices like corporate, and loan pricing as well.

Public goods are like roads, hospitals, schools, etc, which are built by the government and made available to all members of the society without any profit.

“Bond markets were looking for explicit indications on the OMO/OT (Operation Twist) front, which wasn’t given. Hence, markets were a tad disappointed,” said Lakshmi Iyer, chief investment officer (Debt) and head of products, Kotak Mahindra Asset Management Company.

Given the enormity of the borrowing value and in the absence of OMOs, market watchers expected the central bank to allow the yield on the 10-year benchmark government paper to move up to 6.20-6.25 per cent.

“While the RBI might continue to manage the yield curve through OMOs and Operation Twist (perhaps more aggressive intervention in case the yield moves beyond 6.20-6.25 per cent), it is unlikely to fixate on keeping the 10-year yield below 6 per cent as it did in 2020. A realignment from both markets and the RBI on yields is only natural,” economists at HDFC Bank said in a note to clients after the policy review was announced.

What has baffled the bond market is the RBI’s move to cancel the auction for yields demanded 3-4 bps higher than the prevailing rates in the secondary market. Clearly, the central bank was not comfortable with the yield on the 10-year government bond climbing over 6 per cent, analysts said.

Madhavi Arora, economist at Emkay Global, said there was a clear communication gap between the RBI and the bond market. “The market is now trying to push the RBI to get into in some action... I think action is now going to speak louder than words. The only way to bring down the term premia is by aggressive OMOs,” she told Business Standard.

According to Arora, the government may have under-estimated tax revenue for the January-March quarter. “They had made a very modest assumption. But what we have seen is that the momentum has picked up. That they have not factored in,” she added.

In the post-policy interaction with the media, Das reminded that RBI had managed the government's borrowing programme rather well in the past. “...We are confident of dealing with the overall situation in the context of the current year's borrowing programme. We are confident of managing it in a very non-disruptive and seamless manner,” he said.

Now, it will be keenly watched who blinks first in this tug of war – the central bank or the bond market.