If the rupee continues to depreciate on falling equity markets and higher oil prices, we expect market interest rates to move higher from the current levels.
Persistent weakness in the emerging markets and surging crude oil price continues to weaken investor sentiment in bonds markets. This led to the rupee touching the low of Rs 74 per dollar and the 10-year government bond yields topping at 8.23% in the past month.
An additional risk emerged in the corporate bonds space after the IL&FS and its subsidiaries defaulted on their debt repayments. This spread to broader NBFC companies as concerns on refinancing impacted share prices and bond yields of many NBFC issuers. Even the AAA PSUs were not spared and 2-3-year PSU bonds got traded at around the 9.0% mark at peak.
Meeting liquidity needs
The RBI released multiple press statements to assuage the market on meeting liquidity needs of the system and also announced Open Market Operations (OMO) and Term Liquidity Repos. The RBI conducted an OMO of Rs 200 billion in September and announced intention to purchase total of Rs 360 billion of government securities under OMO in October.
The government also moved in to ease the pressure from the bond markets by cutting its second half borrowing programme by Rs 200 billion. These measures led to a relief rally in the bond markets and the 10-year yield dipped below 8% mark on the announcements. But it could not sustain there for long and retraced back to 8.20% following sharp rise in crude oil and the US treasury yields.
Another positive surprise came from RBI as in its bi-monthly monetary policy, the MPC decided to keep the policy rates unchanged at 6.5% against the market expectations of 25-50 bps hike. The 10-year bond yield eased again to near 8% post policy announcement.
With this move, RBI has sent a message to the markets that it won’t use interest rates to defend the depreciating currency.
Earlier rate hike
The RBI having already raised interest rate by 50 bps in the last four months also drew comfort from slowing inflation. CPI inflation, especially food inflation, continues to shoot below RBI’s projections and the previous two pre-emptive hikes does ensure that the RBI repo rate is ahead of the current inflation trend.
However, given the trajectory of oil prices, if it stays at the current levels or moves up further, we would see the RBI hiking rates in the forthcoming policies. We thus expect the repo rate to move up to 7% from the current level of 6.5% by March 2019.
With the OMO support and lower borrowing, the 10-year government bond yield may hover around 8% for now and move towards 8.25% if the market expects RBI to hike by more than 50 bps. As for now, we still do not expect 10-year government bond yields to go up considerable above 8.25% unless macro situation changes materially.
If the rupee continues to depreciate on falling equity markets and higher oil prices, we expect market interest rates to move higher from the current levels. Also, risks in the system would rise and investment sentiment will fall. In such a scenario, we would advise investors to remain invested in debt funds which prioritise safety and high liquidity and manage money with prudence by being true to the investment objective of the fund.
We have always advised investors in general to have a longer time frame if they invest in bond funds and should also note that the bond fund returns are not like fixed deposit returns and can remain highly volatile or even negative in a shorter time frame.
-The writer is fund manager, Fixed Income, Quantum AMC