Abheek Barua: Beware of momentum

The Indian bond and credit markets cannot buck the international trend in the longer term.

The Indian ten-year government bond yield has come down by a little less than a percentage point from the peak of 8.40 it touched in July. The downward momentum has been particularly sharp in September, with anxious traders buying bonds at every uptick in prices to make sure that they don't miss the rally. (Remember, bond prices move in the opposite direction as their yields""a decline in yields means a rise in prices.) The expectation in the market, despite some rather bearish sound-bytes from the Reserve Bank governor on Thursday, September 28, is that the yield will drop further. This of course does not automatically mean that bank lending rates will come down. However, historically credit markets have trailed the government bond market by a few months""thus if yields drop or stay put at current rates, it could mean that domestic bank lending and deposit rates are peaking.

There are two things about the recent rally that I am a little uncomfortable with. The first is the sheer pace of movement. Strong momentum in asset prices, whether they are stocks, bonds or exchange rates, often presage a sudden reversal in direction. I wouldn't be entirely surprised if yields started climbing up again. The other source of my discomfort is the fact that the domestic markets have mimicked the US market a little too closely despite the fact that the macroeconomic fundamentals underpinning the two markets are completely different.

I refer here to the fact that the yield curves in both the markets have flattened almost continuously, a phenomenon that traders and economists tend to take rather seriously. The yield curve is the line that runs through yields of different maturities and a flatter curve simply means that the difference between long- and short-term yields has decreased. Economists bother with this because this kind of flattening has historically augured a slowdown in economic growth (perhaps even recession) with declining inflation as a concomitant.

The change in the shape of the curve captures current economic conditions in the US almost to the tee. A number of leading indicators, to use the jargon, including the housing market, seems to suggest that the economy is cooling off. Price pressures linger but the US Federal Reserve's decision to put its policy rates on hold since August suggests that it is betting on slowing growth and demand to rein in inflation.

India's current economic situation is quite the converse. Most analysts that I know have revised growth estimates upwards either for the companies they track or for the economy as a whole. First-quarter GDP growth for 2006-07 was 8.9 per cent and the consensus expectation seems to veer towards 8.5 per cent growth for the year. Headline inflation might still print at levels below 5 per cent but the steady rise in the manufactured product and primary product indices is difficult to sustain. In fact, as the so-called "base effect" (high levels of inflation in 2005 tend to depress current year inflation since inflation is measured year on year) wears off by October, headline inflation might creep up again. Oil prices have come off globally but with the huge losses that oil marketers have borne over the last couple of years, it is unlikely that the government would want to change retail prices of key fuels in a hurry. If this indeed the current shape of the economy, it certainly just does not justify a persistent flattening of the yield curve.

In short, I expect some increase in the wedge between short- and long-term rates going forward. Long bond yields (five- to ten-year bonds in our case) are likely to start moving back up and short-term rates, which have remained somewhat sticky through the rally, could come down a little. Banks are unlikely to cut loan rates immediately and lower short-end rates could reduce their cost of borrowing a tad and shore up their net interest margins. The RBI appears to be visibly uncomfortable with the sharp fall in yields and traders should brace themselves for some tough talking from our central bankers, aimed at talking long yields up. If talking doesn't do the trick, there is a possibility of the central bank actually raising its policy rate due at the end of October, when the RBI announces its mid-year monetary policy.

Having said this, let me also point out that I wouldn't entirely ignore the signals that the global liquidity regime seems posed for sustained change. Global growth, particularly that of the US, seems to be slowing down at a somewhat sharper pace than markets had expected. Central bankers appear to be shifting their focus from fighting inflation to fighting a severe slowdown. For instance, unless economic activity data suddenly start perking up again, the US Federal Reserve is unlikely to hike its policy rates. In fact, a section of the economist and investment banking community believes that the Fed might actually start paring its policy rates in early 2007. Thus, globally liquidity could be headed up and interest rates down next year.

Despite India's relative insulation from the global market and the fact that domestic economic growth remains robust, the Indian bond and credit markets cannot buck the international trend in the longer term. The simple fact that domestic companies are allowed to raise external borrowings means that local banks have to re-price their loans to make sure they don't lose custom. This is an eventuality that bankers need to prepare for.

However, transitions in regime such as these don't happen overnight and markets remain extremely choppy in these phases. Thus, it is good to be cautious about sharp one-way movements in prices like the rally. Beware of momentum.

The author is chief economist, ABN Amro. The views here are personal