An important and usually reliable measure of the future economic outlook is the yield curve in the bond market. It is particularly useful when the overall economic environment is highly uncertain, such as now. The yield curve shows the yields of government securities (G-Secs) of various maturities. The steepness of the yield curve is often used as a proxy for market expectations about future interest rates, and hence future inflation and growth. In recent times however, the reliability of the yield curve and its information content have come into question.
One simple way to measure the steepness is the term premium. It is the difference between the yields at the short end and at the long end of the yield curve. In India, the long-term yield considered is typically the 10 year G-Sec yield while for the short-term, it is usually the yield on one-year treasury bills. Monetary policy has an important impact on the term premium. The actions of the central bank directly affect the short-term interest rate. The bond market interprets the central bank’s actions and statements and transacts long dated bonds setting the long-term rates.
Since May 2022, the RBI has been hiking the policy repo rate in response to the rise in CPI (consumer price index) inflation which averaged at 6.8% between January and August 2022. Accordingly the short-end of the yield curve has gone up from 5.1% in early May to 6.7% now. This is a move of around 160 basis points in the 1 year G-Sec yield.
The RBI has also been highlighting in its monetary policy statements the significant upside risks to inflation that remain a concern. It has specified that it will continue to withdraw surplus liquidity from the system which is consistent with a contractionary monetary policy. Its CPI inflation forecast for FY 2022-23 is 6.7%, much higher than its inflation target of 4%. This implies that monetary policy may need to be tightened in a calibrated manner for the next few quarters.
Moreover, monetary policy tightening in the US has led to a strengthening of the US dollar and accordingly an 11% depreciation in the rupee-dollar exchange rate in 2022 so far. This has been the fate of currencies across the world, not just in emerging economies, and has led to central banks raising interest rates in order to defend the exchange rates. There are talks among the analyst community in India that the RBI might follow suit. Given that the Fed has said it might increase interest rate by another 125 basis points by the end of 2022, any attempt to use monetary policy to defend the rupee’s value may require the RBI to raise rates significantly.
Given the circumstances, one might expect the yield curve to steepen i.e. long-term yields should go up alongside the short-term ones, reflecting market’s expectation of higher interest rates in the future.
What we see instead is that the rates at the long-end of the yield curve have gone up by only around 30 basis points – from 7.1% in early May to 7.4% now in comparison to the increase in the short end by about 160 bps. As a result, the term premium has come down to around 50-70 basis points from a long-term average of over 90 bps. This has led to a remarkable flattening of the yield curve which seems counterintuitive.
Such a flat yield curve implies that the bond market believes that the rate actions taken by the RBI would help control inflation, which in turn would lower the chances of future interest rate hikes. In other words, the market does not agree with the RBI as far as assessment of risks to inflation are concerned. It also means the market does not expect the RBI to raise rates to match the monetary policy tightening being undertaken by the US Fed.
If the long-term yields remain as steady as they have been over the last few months, and the RBI continues to tighten the short-term rates, we may soon see the term premium moving close to 0. For an economy growing roughly at 5-6% on average with an inherent inflationary impulse, such a flat yield curve implies that the market is anticipating a severe growth slowdown and hence monetary policy easing.
Is that indeed the case? The answer is: it is not possible to answer this anymore by looking at the yield curve. Let's understand why.
During the pandemic the RBI had expanded its balance sheet by around 25%. It bought long-term G-Secs and the 10Yyields were held steady around 6%. Since October 2021 it has stopped its bond buying program. At its peak the RBI’s balance sheet was around Rs 65 trillion in October 2021. Between then and September 2022 the balance sheet has shrunk marginally to around Rs 59-60 trillion. This means that while the RBI has been withdrawing short-term liquidity using the SDF and reverse repo facilities, it has not been selling long-term G-Secs.
Typically, the RBI withdraws long-term liquidity through open market operations (OMOs) or by selling dollars from its reserves. In the former case, the stock of G-Secs goes down, and in the latter, reserves fall. The RBI has lately been relying on the second mechanism - selling dollars - to reduce liquidity (and to stem the rupee depreciation). When the RBI’s GSec holdings were small, this did not matter. Now the RBI potentially holds around Rs 15 lakh crore worth of G-Secs which is tad below 20% of all outstanding G-Secs, compared to its peak holding of Rs 15.8 trillion in September 2021. In contrast, between 2011 and 2020, the average RBI ownership of G-Secs was roughly 11% of the outstanding. As long as the RBI continues to hold such a large amount of G-Secs, the long-end of the yield curve is unlikely to respond freely to economic conditions.
A natural way for the term premium to shrink is if inflation comes down or growth slows down. But if in some part of the market there are no transactions, and a large chunk of the supply of long-dated bonds is cornered then this hampers price discovery. All interest rate sensitive securities are directly or indirectly priced with reference to the yield curve. Any such distortion of the yield curve therefore will translate into an economy wide pricing distortion. This also hampers transmission of monetary policy along the yield curve.
The RBI itself has been advocating an “orderly evolution of the yield curve”, but its own decision has important consequences for the market in general and the yield curve in particular. The current compression of the term premium suggests that the yield curve is anything but orderly.
No comments:
Post a Comment