Those not familiar with the idea of bond yields could think of them as real-time interest rates that emerge from the balance of demand and supply in the bond markets. Thus, like any other interest rate they should rise with inflation and fall if the central bank signals a fall. The benchmark yield (the bond market's Sensex or Nifty) is the 10-year bond yield. The funny thing is that despite an uptick in inflation, the 10-year yield has dropped by a whopping 65 or so basis points (a hundredth of a percentage point) since January this year. Put somewhat crudely, the bond markets have signalled that interest rates have dropped by half a percentage point and some more. Despite a somewhat tepid credit policy on the 9th of this month that did not touch the policy rate and raised concerns about rising inflation, the yield continued to fall.
What explains this and will bond yields continue to drop further? A clue to this somewhat strange behaviour lies in the unanticipated events that hit the domestic and global markets. First, there was the so-called "Rexit" (Reserve Bank of India Governor Raghuram Rajan's decision to quit in September). Quite contrary to the apocalypse that many analysts had predicted, markets took the news calmly. Bond markets seemed to have cheered the decision, hoping that his successor would be more willing to follow an easier monetary policy line. That is, Rajan the "hawk" would be replaced by a "dove".
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While this expectation did have some role in bringing yields down, a far more critical change happened on the global front - Brexit. In the temporary anxiety that followed, emerging markets that had been beaten up badly earlier, suddenly emerged as a safe haven. Most emerging market bonds led by Brazil and Indonesia saw a sharp drop in yields as global funds pumped funds in. Indian bond markets rode on this bandwagon. This gush of money was underpinned by the fact that if the UK's decision to leave the European Union were to lead to a global recession, central banks would crank up their money machines.
Central bank reactions have been a mixed bag. The Bank of Japan, which a number of analysts believed would lead the monetary binge, did not oblige. The Bank of England somewhat predictably slashed its policy rate and embarked on quantitative easing. The US Federal Reserve held off on a rate hike citing the spillover from Brexit. However, employment and consumer spending have been strong and were inflation to continue its slow march north, the Fed would have to respond with a rate hike.
The RBI is actually infusing much more liquidity than anticipated in its bid to restore what it calls "liquidity neutrality" and doing its own version of slightly unplanned quantitative easing, hoping that will lead to a fall in borrowing cost. In an unexpected move, the RBI infused Rs 10,000 crore of cash into the system, taking the benchmark bond yield to a seven-year low of 7.08 per cent.
The problem with all this is that as bond yields keep climbing down, the possibility of a reversal increases. Bond prices vary inversely as bond yields. With inflation at over six per cent for July, the market may find a trigger to sell bonds, bringing the rally to a halt. This could bring to an end yet another bubble that was waiting to be burst.
Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is principal economist, CII