Bond yields have been on an upward trajectory due to a variety of reasons, including demand-supply mismatch, concerns over inflationary pressure, rising oil prices, higher US Treasury yields and fiscal deficit fears.
Markets are keeping a close eye on a possible revision in the inflation estimates of the Reserve Bank of India (RBI) on Wednesday, when it is set to announce its sixth and the final bi-monthly monetary policy for 2017-18. This will likely guide the direction of interest rates, even if there is no rate action immediately. Observers are also keenly looking out for any steps the central bank might take to boost market demand for central government securities, which are seeing reduced buying by public sector banks. Although inflationary concerns are reflecting in the current bond yields, market participants expect RBI might keep rates unchanged but signal a more hawkish stance. Bond yields have been on an upward trajectory due to a variety of reasons, including demand-supply mismatch, concerns over inflationary pressure, rising oil prices, higher US Treasury yields and fiscal deficit fears. The old benchmark bond—6.79% yielding note maturing in 2027—has already seen yield rise by 85 basis points to 7.74% over the past three months.
One of the major causes of concern on inflation is the government’s decision to keep the minimum support price (MSP) for all unannounced crops of kharif crop season at one and half times of their production cost. “If price of the agriculture produce market is less than MSP, then in that case government should purchase either at MSP or work in a manner to provide MSP for the farmers through some other mechanism,” finance minister Arun Jaitley had said in his budget speech.
Furthermore, oil prices have been rising over the last few months. Between June and January, Brent crude price has risen $26/barrel, having hit the $70/barrel mark a few days back. The finance minister recently said that a $70/barrel price is in the outer periphery of the government’s comfort threshold. A DBS Economics report points out that while the modest cut in the fuel excise duties will help mitigate the pressure from higher oil prices, the RBI will closely watch the spill-over from the proposed MSPs into rural/farm wages and, by extension, demand conditions. “This will, however, be hard to quantify due to scant details.
In the past, a sharp increase in MSPs has led to high food inflation and generalised price pressures,” the report said. In its fifth bi-monthly monetary policy in December, the central bank had revised its inflation estimates to 4.3-4.7% in the third and fourth quarter of this year, including the HRA effect of up to 35 basis points, with risks evenly balanced. This was an incremental revision of 10 basis points from the estimates made in the October monetary policy.
A Bank of Amercia Merrill Lynch research report states that inflation risks are overdone. “Our oil analysts also expect oil prices to come off by 10% to $62/barrel by December 2018. Not surprisingly, core inflation (ex: food, fuel and HRA) is hovering about a reasonable 4.2%. That said, we do worry about poor rabi sowing in the interim. Although Budget 2018 has raised MSP, the inflationary impact will likely be limited as the revised MSPs are still below market prices in many cases,” the report indicated.
The market is expecting the central bank to provide some comfort to address the demand-supply dynamics in the bond market. Public sector banks (PSBs) have reduced their buying in the central government securities market as they are believed to have taken considerable marked-to-market losses in the third quarter on surging yields. RBI deputy governor Viral Acharya had earlier said that the central bank couldn’t give PSU banks a special dispensation when they had sought more time to absorb the losses. A primary dealer said that he expects the central bank to review the foreign portfolio investors (FPI) investment limit in central government securities. “The RBI might give some indication of how much the limits could be opened going forward, although it could come into effect in April only. The very visibility of more FPI participation could give some relaxation to the yields,” the dealer said.