Why are 10-year bond yields headed downwards?

Since the beginning of the calendar year the yield on 10-year G-Sec bonds has fallen from a high of 7.87% to the current level of 6.6%. The last time the 10-year G-Sec touched such a low level was back at the peak of the financial crisis in 2009 when central banks across the world were on a rate cutting spree to make adequate liquidity available at cheap rates. But, scratch the surface and the difference becomes a little more surprising. During the 2009 crisis, the repo rates were at a level of 4.75%. So the 10-year G-Sec yield at around the 6.5% level was perfectly understandable. But currently, the repo rates are at 6.25% (after the October monetary policy) but yields are already at the same level as 2009 when the repo rates were at 4.75%. So what exactly has driven this sharp fall in yields?

The MPC has made a lot of difference…

The Monetary Policy Committee (MPC) was always coming but the entire initiative got a further thrust after Dr. Rajan announced that he would not be seeking a second term as the RBI governor. In fact, during the year there was the first fall in yields in June when Dr. Rajan announced that he will not be seeking a second term in office. The second sharp fall in yields came in early September when Dr. Urjit Patel officially took charge. Not surprisingly, the first monetary policy after the new governor took over was announced by the MPC. The MPC has equal representation from the RBI and the MOF.  More importantly, the rate decisions under the MPC will be taken by a vote rather than the RBI governor having the absolute veto powers. This not only institutionalizes the entire process of rate setting but also ensures that the interests of industry are better represented in monetary policy.

Eventually, it is about confidence in low inflation…

A key factor that impacts 10-year G-Sec yields is the trajectory of inflation. India’s CPI saw a sharp fall in the month of August to 5.05% from a high of 6.07% in July. This is one of the sharpest falls in inflation that we have seen in recent times. The trigger for this fall in inflation was a sharp fall in food inflation which fell by over 300 bps during the month of August. Food inflation is the stickiest component of CPI inflation and therefore has the sharpest impact on yield trajectory. With a good monsoons this year as well as expectations of a bumper Kharif crop, the inflation expectations have come down drastically. This has been a key contributor to falling yields at the long end of the yield curve.

Long end is adjusting to the short end of the yield curve…

Over the last few months, the RBI has made a distinct shift in strategy. It has shifted its core strategy from giving rate signals to giving liquidity signals. Since the beginning of the year, the RBI has conducted open market operations (OMOs) to ensure that the liquidity deficit is brought down to neutral levels. A comfortable liquidity situation impacts yields at the short end like call rates, 90-day T-Bills, 364-day T-Bills, CP, CD etc. We have already seen a sharp fall in yields in the short end as they have fallen by over 100 bps during the year due to adequate liquidity. This depression of yields at the short end of the curve has also resulted in bringing down yields at the long end. With the RBI likely to keep liquidity abundant in the money markets through OMOs, one can expect further pressure on yields at the long end.

Huge demand for G-Secs from institutions…

There has been a huge demand for government debt from domestic and foreign institutional investors. Domestic mutual funds have invested over $45 billion in government debt during the year. This is largely driven by expectations of a further fall in rates and also because domestic institutions have been worried about equity valuations. A falling rate scenario suits debt buyers as it ensures that the capital appreciation will work in their favour. Global investors have been subdued this year due to reaching their limits of debt investment and also because they had multiple options of economies to invest in. But then Indian debt yields continue to be one of the most attractive! Additionally, considering that the Indian rupee has been largely stable or calibrated downwards, the dollar yields on Indian debt continues to be attractive. So demand from institutions will continue to be buoyant. Strong demand for debt will take bond prices up and therefore yields down. Alternatively, the heavy demand will enable the GOI to meet its debt needs at lower cost. Either ways, long term yields are poised to move lower.

The sharp fall in yields since the beginning of the year can be attributed to a combination of factors like low inflation, low rate expectations, buoyant demand and yield curve adjustment. The trend, at least for now, appears to be downward.

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