Budget 2018: Bonds sold off on Monday after the market interpreted a hawkish tone in the monetary policy comments of chief economic advisor Arvind Subramanian. After the Economic Survey was tabled, Subramanian stated in a press conference that if the output gap (the gap between the actual output and maximum potential output) narrows, the stance on monetary policy will have to change. “Now, clearly the cycle has turned. Inflationary pressures have re-emerged. So, it’s not just that inflation is picking up but also the fact that if growth happens, output gap will also start narrowing. So from both those perspectives, the stance on monetary policy naturally has to change. As Keynes famously said: When the facts change, I change my mind. What do you do sir? So, I think there has been a change in the underlying facts,” Subramanian said. Another part that seemed to have added to the nervousness in the markets was the statement on fiscal consolidation. The Economic Survey document stated that setting overly ambitious targets for consolidation – especially in a pre-election year – based on optimistic forecasts that carry a high risk of not being realised will not garner credibility. “Pragmatically steering between these extremes would suggest the following: a modest consolidation that credibly signals a return to the path of gradual but steady fiscal deficit reductions,” it said.
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The ten-year benchmark yield rose 13 basis points to close at a 19-and-a-half month high of 7.44% on Monday. Till afternoon, the benchmark yield was up just three basis points. Only in the second half did the sell-off accentuate. The yield on the old benchmark bonds too closed 15 basis points higher at 7.63% on Monday. Market experts point out that apart from the consolidation of positions ahead of Budget, the market seemed to have misinterpreted the CEA’s comments on the monetary policy stance.
Ananth Narayan, professor-finance, SPJIMR, confirms, “I think the market misinterpreted his comments. I think he was referring to his earlier call for lower rates, and acknowledging that the time for rate cuts is now past, rather than calling for rate hikes”. The Economic Survey states, “The IMF is now forecasting that advanced country output gaps will close in 2018 for the first time since the Global Financial Crisis. As this occurs, wages would start rising, eating into profits (which would prick equity valuations); and as inflation rises in tandem, policy makers would be forced into raising rates, deflating bond valuations and further undermining share prices”.
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However, Monday’s sell-off can also be attributed to the adjusting of positions by bond market participants ahead of the Budget, according to Ajay Manglunia, EVP at Edelweiss Securities. “It seems nobody wants to do value buying, which is reflected in the fact that everybody is pruning their positions in order to balance their portfolio. A part of the selling seen on Monday could also be attributed to this fact,” he said.
It is noteworthy that the credit derivatives market is in a nascent stage in India as a result of which, very little hedging activity takes place in the bond markets. Ahead of an important event, market participants consider consolidating their positions rather than hedging their exposures using derivatives although interest rate futures and overnight interest swaps have been permitted by the central bank.