Yield curve steepens, signalling growth

Real interest rates on up to 10-year gilts negative.

With the rate of inflation touching 5.89 per cent, real interest rates on government bonds up to 10 year maturity have turned negative. The yield on the benchmark 10-year gilt closed at 5.80 per cent on Monday.

The wholesale price index-based inflation rose to a four-month high of 5.89 per cent for the week ended June 12, higher than 5.55 per cent in the previous week and 5.03 per cent on May 29.

With inflation set to climb further on rising energy prices, a section of the market feels the yield on the 10-year paper could inch up. The government bond yield curve in the first quarter of the current financial year (April-June) has stiffened, indicating a bullish outlook on growth and portending a hike in interest rates.

For instance, the yield on the 10-year bond, which was 5.12 per cent in April, has gone up by 68 basis points (one basis point is one hundredth of a percentage point) to 5.80 per cent. In contrast, the yield on the one-year paper, which was around 4.42 per cent in April, has gone up by 23 basis points to 4.65 per cent. This means that the spread between the one-year and 10-year gilt, which was 70 basis points in April, has widened to 115 basis points.

"The yield curve, which was flat for about a year, is now stiffening. This is in line with market expectations. This may stiffen further, but we do not expect any dramatic change (in rates)," said the treasury head of a public sector bank.

The interest rates on longer maturity paper are, however, still above the inflation rate. For instance, the yield on the 11-year paper is 5.96 per cent, on the 13-year paper 6.14 per cent and on the 30-year paper 6.35 per cent.

In contrast, the real interest rates of virtually all US gilts are positive. The yield on the 10-year US treasury bill is around 4.65 per cent against an inflation rate of 3.1 per cent, a real interest rate of 1.55 per cent. The 5-year US paper is trading at 3.83 per cent, again higher than the inflation rate.

Wholesale inflation had climbed to a 35-week high of 6.09 per cent on January 3. At that time, all secondary market yields of Indian gilts were below this level.

Analysts said the government bond interest rates were likely to go up further as inflation expectations were now on the higher side. The Reserve Bank of India has projected an inflation rate of 5 per cent in 2004-05 but warned that "the inflationary situation needs to be watched closely and there could be no room for complacency on this count".