Amid hushed murmurs over an intense rally in the benchmark 10-year bond yield, the Reserve Bank of India (RBI) has said that the government has decided to cancel its ₹20,000 crore borrowing scheduled for March 26, at the fag-end of the fiscal. The central bank said on March 22 that the decision was taken after a review of the cash balance position.

For the market, the decision was not completely unexpected. “We were in fact anticipating two auctions to get cancelled. But only one got cancelled. The government is sitting on a comfortable liquidity position,” said the head of fixed income group at a diversified financial services organisation.

Some traders believe that a spike in direct tax collections, which is likely to push the revenues above the revised target, has helped the cash reserves get bigger. This, they believe, may soften the yields for government securities (G-secs) by the month-end. But it is only a temporary blip before the yields begin to flare up.

After the Covid-19 pandemic battered economies in the first half of 2020, central banks around the world had significantly lowered interest rates and launched massive debt purchase programmes to boost borrowing. This sent yields down and bond prices up. But the yields began to gain strength as the pandemic showed a declining trend and economies went back to the growth curve.

The RBI has been on a constant vigil on the spike in bond yields. After having averaged 5.93% during April 2020 to January 2021, the 10-year bond yield had soared to 6.23% by the first week of March. The 10-year bond yield reflects the growth and inflation mix in the economy.

According to an article in the March edition of the RBI’s bulletin, the impact of a slew of measures announced by the RBI on February 5, 2021, did not last long. Though the benchmark dropped to 5.96% by February 11, the subsequent weeks saw another round of its increase. Global spillovers in the form of hardening crude prices, announcements of fiscal stimulus, fears over inflation, and a lukewarm response to the U.S. Treasury’s primary auction had apparently sparked a worldwide stampede in bond markets. As the U.S. 10-year benchmark surged to 1.6% from around 1%, bond markets in India were roiled by persistent selling and shorting, said the article. Titled ‘State of the Economy’, it was written by a clutch of in-house experts led by RBI deputy governor Michael D. Patra.

Soon, the RBI had swung into action. Its announcements of large-sized operations breathed a brief calmness into the market, but the subsequent spike in U.S. yields pushed up yields in India as well. On March 10, it touched a high of 6.25%.

The article cautioned that bond vigilantes could undermine a global economic recovery, unsettle financial markets, and trigger capital outflows from emerging markets. “The Reserve Bank is striving to ensure an orderly evolution of the yield curve, but it takes two to tango and forestall a tandav,” said the article.

The message was loud and clear. The bond markets across the globe are hampering the nascent recovery. “Bond vigilantes are riding again, ostensibly trying to enforce law and order on lawless governments and central banks but this time around, they could undermine the economic recovery and unsettle buoyant financial markets. Fears over U.S. interest rates have already started spilling over on to emerging market economies (EMEs). Investors have started pulling out money from EME stocks and bonds in an abrupt ending of a streak of inflows that had remained uninterrupted since October 2020,” it said.

The RBI has quoted the Institute of International Finance (IIF) which has pointed out how foreign investment turned negative in emerging market equities and debt from the latter part of February, bringing back fears of the 2013 taper tantrum. Though many emerging economies are in better shape today than in 2013 in terms of the external balances and debt profiles, they are not immune, said the article.

A market participant agreed that some traders are indeed shorting. “In my opinion, shorting G-secs makes no sense,” he said.

After the Covid-19 pandemic battered economies in the first half of 2020, central banks around the world had significantly lowered interest rates and launched massive debt purchase programmes to boost borrowing. This sent yields down and bond prices up. But the yields began to gain strength as the pandemic showed a declining trend and economies went back to the growth curve. The RBI has been on a constant vigil on the spike in bond yields. After having averaged 5.93% during April 2020 to January 2021, the 10-year bond yield had soared to 6.23% by the first week of March. The 10-year bond yield reflects the growth and inflation mix in the economy.

The increase in yields means that the cost of borrowing for both central and state governments is on the rise. Traders say that the most important factor that influences a bond is the prevailing interest rate in the economy. When interest rates rise, bond prices fall, leading to a spurt in the yield of the older bonds and bringing them in line with the newer bonds being issued with a higher coupon.

“Bond yields will continue to stay at an elevated level. The government borrowing for 2021-22 is going to be huge. There is also an element of expectation of higher inflation, going forward. Credit growth, which was subdued in the current fiscal, is going to be better,” said a Mumbai-based wealth manager.

The Budget had pegged the borrowing target for the current fiscal at ₹12.8 lakh crore. According to the revised estimate, it was raised to ₹12.8 lakh crore, an increase of 64% from the earlier estimate of ₹7.8 lakh crore.

The borrowing target for the next fiscal is also a similar amount. “The gross borrowing from the market for the next year [2021-22] would be around ₹12 lakh crore. We plan to continue with our path of fiscal consolidation, and intend to reach a fiscal deficit level below 4.5% of GDP by 2025-2026 with a fairly steady decline over the period,” finance minister Nirmala Sitharaman had said while announcing the Budget for 2021-22.

A bond dealer said the market will wait to see how the government raises funds in the next fiscal. “The open market operations (OMO) calendar for 2021-22 is not yet out. The government borrowing will be around ₹12 lakh, which is equal to what they raised during the current fiscal. Generally, 60%-70% of the borrowing will be front-loaded in the first half. The demand is much lower as a bulk of the government securities are picked up by banks and insurance companies. A potential spike in the interest rate going forward would mean a mark-to-market loss for banks. This is why an excess supply will push up the yield,” he said. He has forecast a jump to 6.7% levels.

A rise in yields points to a rise in interest rates in the economy. Yields are also a reflection of the central government’s market borrowings. Higher yields translate into higher borrowing costs for the governments and companies, hurting their ability to service debt and make new investments. It will create a roadblock to the central bank’s efforts to get the economy back on the growth track.

“With an expectation of higher inflation and high fiscal deficit, there is a strong case for an interest rate hike in the next fiscal,” the bond dealer said.

“The RBI, however, wants to signal to the market that it doesn’t want to see any hike in rates,” said the dealer, adding that the government may find it tough to borrow money at lower rates.

Another bond dealer, however, said the yields will be range-bound at 6%-6.25%, with an upper limit of 6.35%. “Crude has now slipped much below after coming close to $70. After weakening through most of 2020, the U.S. dollar is likely to get strengthened,” he said.

As always, the RBI is keeping a close watch on the bond yields. It can’t afford to let the market get pit-roasted.

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