The spike in both inflation print as well as in the benchmark yields indicate that the bond market is in the grip of stagflation, and the higher yields are here to stay, warns a report. The 10-year G-sec yields have climbed up rapidly by 35 basis points (bps) over the last three weeks, while the July inflation print is 50 bps above the upper end of the Reserve Bank’s tolerance level, thus virtually closing the rate cut window in the medium term, a report by Acuite Ratings said on Friday.
The yield differential between two-year and ten-year bonds has again expanded since the monetary stimulus announcement and as on August 24, the differential was over 180 bps, back to the levels seen on April 24.
Moreover, the effective annualised forward rates for a two-year and ten-year zero coupon bonds are substantially higher by 66 bps and 32 bps, respectively, highlighting the market concerns on the longer-term impact of inflation.
“These are early signs of the yield curve adjusting itself to a higher level,” warns the report.
The spike in bond yields augurs that borrowing costs will go up not only for the government but also for corporates despite ongoing accommodative monetary policy and that open market operations (OMOs) may yield the desired result for the central bank to tame the yields given the twin concerns on inflation and fiscal deficit.
“We believe that the rate cut window is virtually closed in the short-term and there is a significant likelihood of a change in RBI’s accommodative policy over the next three to six months particularly if the retail price index doesn’t come down,” the report said.
The initial trigger for the spurt in the bond yields was the MPC decision to hold the rates, citing the spike in the inflation print on August 6. Core inflation has actually moved up by 50 bps in July 2020, surprising the market that was expecting the base effect factor to start to moderate inflation in the short-term.
“But such a scenario has enhanced the risks of stagflation, which implies a painful phase of high inflation but low or negative growth, aggravating the challenges currently faced by the policymakers,” the report said.
The other significant headwind for the bond yields is the massive spike in fiscal deficit. Although the initial budget estimate projected gross borrowing of Rs 7.9 lakh crore, the same has been hiked by nearly 50 per cent to Rs 12 lakh crore after the pandemic hit the economy and government finances.
And by the second week of August, the government has already borrowed 49 per cent of the revised borrowing estimates or Rs 5.5 lakh crore, taking the gross debt raising to 70 per cent. Similar trends are seen among state debt raising too.
This, the report warns that, also increases the concerns in the market regarding the possibility of higher fiscal deficit, which may double from the budgeted 3.5 per cent. “The higher borrowings will lead to an oversupply of sovereign papers, putting further pressure on the yields. This is more so because most banks hold excess SLR, and the continued participation of the FIIs will be a key factor in stabilising the yields,” the report said.