Is the Indian bond market overreacting to Monetary Policy changes? B Prasanna answers

Time of India

14 hours ago

B Prasanna
, Group Executive, Head - Global Markets & Proprietary Trading Group,
ICICI Bank
, says following a shift in sentiment and
bond market
adjustments, a new equilibrium is expected within the next week as interest rates settle, influenced by falling inflation and anticipated US rate cuts. The terminal repo rate might target 5.25%. Investors may favor the short end of the yield curve, up to five or seven years, while the long end might underperform.
After the announcement of the
monetary policy
, we have seen the one-year bond yield declining and that of the longer duration ones increasing, leading to an increase in spread between the short and the long-term yield curve. How do you see this phenomenon and where is it going to be headed next?
B Prasanna:
What really happened in the RBI policy was a little bit of a surprise to the markets. There were a couple of positive surprises in the form of 50 bps rate cuts instead of 25 bps ones and there was a CRR cut which was not expected. On the other hand, there was a hawkish surprise in the change in stance from easy accommodative policy to a neutral stance which was not again expected by the market.
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What it led to that day and in the subsequent days is the repricing of the interest rate trajectory. What the market was expecting was for the repo rate to be cut to 5.75% and then to 5.5% in August and maybe people were even willing to look at 5.25& or even 5% as a terminal repo rate. By virtue of RBI changing the stance and also by virtue of the fact that they very clearly said there is very limited space for monetary policy to be accommodated rate to anymore, it led to repricing of rate expectations in the market.
Typically when rate expectations change, we see the long end reacting first. So, we saw anything upwards of five-year whether it is a seven-year or ten-year, and the thirty-year bond yields going up, but the short-end did not really react on Friday when the policy happened primarily on account of the liquidity surfeit which is available. But post that, we have seen the short-end yields going up because RBI, and the governor as well did not make a very positive comment that VRRR auctions will not be made.
In fact, he said they will be sitting and deciding whether to suck out liquidity using VRRR at the extreme short end and that had led to some kind of a negative reaction on the short end as well. So, all in all,it was a very positive policy but we had a typical bond market reaction which was negative across the curve. I maintain that this policy is a policy for the real economy where the benefits are going to be availed by the borrowers and the lenders directly because of the fall in EMIs and fall in deposit rates.
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But with the yield curve steepening, do you expect the bond holders moving to a shorter duration bond as the long duration bonds may underperform a steepening yield curve?
B Prasanna:
Right now, the market is possibly over invested in bonds and people are trying to figure out what is the right level of bonds considering that the stance change has happened. We saw a little bit of a shift in sentiment and people are exiting bonds whether it was short or long or medium-term but over a medium term beyond the next three, four, five days, once stability comes in, once bond markets and interest rates settle at a new equilibrium based on what people think is going to happen going forward because inflation fell and the US is likely to cut rates this year. So, maybe, the terminal repo rate can head towards 5.25% if data were to support.
So, a new equilibrium is going to be formed in the market over the next five to seven days. When that happens, what you are saying will happen which is net-net between pre-policy and a steepening of the yield curve, we see people getting back into the short end of the curve. Maybe up to five years, seven years, and ten-year might be neutral whereas the long end might not behave as well. That is where we are as far as the interest rate curve is concerned.
I want to talk to you about Indian bonds in the backdrop of US bonds because the yield gap between India 10-year and US 10-year treasury bonds has declined to 1.8% from 2.2% at the start of this calendar year. How do you see this in terms of flows into Indian bonds?
B Prasanna
: There are two things. The second thing is what is happening to flows and the first thing is can
Indian bond yields
sustain this trend where the differential is really narrowing? What needs to be kept in mind is the kind of positivity that is there in the Indian macro at this point of time, where even with a widening current account deficit, it is still less than 1% of GDP.
There used to be times when it was 4% or 5% of GDP. Then, the services and the remittances are doing well to support a widening trade deficit. We have a balance of payment which is broadly at balance even though net FDI inflows are not coming in as much. Usually when the interest rate differential narrows down a lot between the Fed rate and the RBI repo rate, if the current account deficit is poor, then there can be a run on the currency by virtue of outflows and all that.
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We are seeing none of that happening primarily because of the excellent macros. It looks like this time it is different and can sustain a narrow interest rate differential. Now to the second question of what is happening to the flows, that is a valid question because international investors who are looking to invest into various countries and doing allocations, still have a choice. They can choose not to invest in a country which has a depreciating currency and a very narrow interest rate differential. They might not come in but there will be passive investors tracking the index in which India is now a part of and likely to become a part of a few more indices as we go forward.
Those AUMs will come into India over the next few months. But if you are talking about active bond flow investors, it is a little difficult to attract flows with interest rate differential being so narrow. Also bear in mind something else which is happening and which is favouring India. There is a medium-term dollar weakness story which is now coming up in the last couple of months because of which, the international investors have now figured out that there is no country in which they can invest without any true currency risk.
In the past, it used to be the US where people invested from across geographies and did not hedge the currency, the US dollar. But right now, it looks like the dollar index is in a weakening trend from a weakening perspective. That is helping the Indian rupee and helping money coming into India. At some point of time in the future, we can get back those flows.
What about the
FAR bonds
because they have seen big selling in the first quarter of the fiscal. What is leading to this and what are your expectations going forward?
B Prasanna:
That is where the interest rate differential comes into play and to some extent, the narrow interest rate differential is what has led to some outflow. It does discourage but index flows will come in. The active investors might take a little bit more to come. We need to find an equilibrium for us to first settle here because what has also affected us is the fact that the RBI's interest rate stance has changed and so everybody is trying to figure out what is the right level, where is the repo going to settle in this cycle, and how long it will stay in at that level.
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What is the right level of term premium between one year and the ten-year and so on and so forth? It is difficult to give a very clear answer at this point of time, but over a period of time, we will get some solace in terms of inflows.