RBI's change in monetary policy stance ends bond rally

Foreign investors have been net sellers in bond market in past few months but turned positive in Feb

The Reserve Bank of India (RBI)’s sudden change in stance has spooked the bond market. Yields rose sharply on Wednesday after the monetary policy was announced, and has retained those levels. 

But this could also work in favour of the market in the immediate term as the levels seem attractive for fresh foreign investors to come in. 

Foreign investors have been net sellers in the bond market in the past few months, but have turned positive in February. 

Till date this month, foreign investors have invested Rs 6,463 crore in the Indian markets — Rs 4,271 crore in debt and Rs 2,192 crore in equity. 

But on February 8, the day of the policy, existing foreign investors cut their exposures in bonds as rising yields triggered sell calls. However, some of the losses could have been recuperated due to the recent rupee appreciation. 

On policy day, foreign portfolio investors were net sellers to the tune of Rs 674 crore in Indian bonds, as 10-year bond yields shot up 32 basis points. As yields rise, prices of bonds fall. 

The yields on the 10-year bond closed at 6.83% on Monday, up from their pre-policy level of 6.43%. The yields had closed at 6.19% on November 24. Fall in yields is good for existing investors, but fresh investors would want to invest in high yields. 

“The present yield levels are attractive for foreign investors for sure,” said Arvind Sampath, head of treasury at Fullerton India. The rupee’s post-policy appreciation, could be reflecting in the fact that inflows are on their way.  “Higher yields would attract flows and the rupee automatically adjusts itself to reflect that,” Sampath said. 

Going by the sudden rise in yields, it is highly unlikely that bonds would witness the same sort of rally the market enjoyed in the past few months, say bond dealers. This is bad news for domestic investors and banks, who are saddled with huge amount of bond holdings. But US bond yields have been falling too and yield-chasing global investors could be coming back to India to invest. 

Harihar Krishnamurthy, head of treasury at First Rand Bank, said a rise in yields would have happened anyway, but last Wednesday’s movement could have been overdone.  The overnight call money rates are at 6.25%, while the 10-year bond yield before the policy rate was only 15 basis points higher. This indicated almost a flat yield curve, which is not attractive for any serious investors, Krishnamurthy said, adding, “There is a scope for yields to come down. The new normal could be 6.70-75 level.” 

Soumyajit Niyogi, associate director at India Ratings, said the 10-year yields should not cross seven% as there is a “huge appetite for bonds at these levels, given the surplus liquidity condition”. 

The yields at the present level are also good for banks to invest as the excess liquidity they hold, because of demonetisation deposits, would give more returns to banks than they would have earned keeping the money at RBI's reverse repo window, earning 6.25%. 

However, the rise in yields could force banks to raise their lending rates sooner than expected as the marginal cost of funds based lending rate (MCLR) mandates banks to take into account the increase in incremental cost. A spike in bond yields increases the cost of funds for banks and that automatically pushes up deposit and lending rates. 

The rupee, meanwhile, is rising too, largely due to broad-based dollar weakness and considering RBI's neutral stance. 

US President Donald Trump said recently that he would prefer a weak dollar. This led the dollar index to retreat from the 103 level to below 100. As a result, global currencies strengthened against the greenback, the rupee being one of the best performers. The Indian rupee closed at 67.02 a dollar on Monday. Since Trump’s elevation, the rupee has done relatively well against major emerging markets currencies. Since November 8 till date, the rupee has fallen 0.59%, whereas China’s renminbi has fallen 1.33% and the Malaysian ringgit has fallen 5.54% against the dollar. The rupee has been strengthening for some time, following the dollar’s weakness. But RBI’s policy gave a further impetus to the strength of the rupee. 

Satyajit Kanjilal, managing director of Forexserve, said the dollar weakness was predicated for some time, as after Trump’s elevation, the dollar’s strength was a knee-jerk reaction from investors anticipating a risk-averse environment. But barring initial bouts of volatility, the global economy stabilised soon and the markets started scrutinising the large fiscal deficit of the US at a time when the US President was promising a huge spending exercise. 

That led to the weakness in the dollar, which should depreciate further. “If the rupee appreciates to 66.50 level, it won’t be surprising if it goes to 65.50 a dollar level,” said Kanjilal.  According to him, India’s increasing share in the global economy is making it imperative that global cues become more important for the local currency than the domestic factors. Perhaps realising this, RBI has become cautious in its intervention. 

Samir Lodha, managing director of Quantart Market Solutions, a treasury consultant, said RBI seems to be letting the currency appreciate. “There seems to be a change in the approach at RBI. Earlier, there used to be intervention in case the currency swung much, but now RBI is letting the currency appreciate. This is not good for the export sector, which anyway is suffering now,” said Lodha.