During the third week of July, the 10 year benchmark bond yields touched a 20-month low of 6.25%. The last time these levels of yields were seen was in the last quarter of 2017; and that is a long time back. What is surprising is that this fall has been really rapid after it breached the 7% mark. In fact, a recent report by Deutsche Bank has pegged Indian benchmark yields as closer to 5.5% by next year. What does this really mean for investors?
Decoding bond yields
Bond yields have been largely a function of the rate direction set by the RBI as well as the liquidity in the system. Bond yields do tend to taper when there is substantial liquidity in the system as we got to saw during the aftermath of the demonetization in November 2016. But bond yields in India have followed a curious path in the last one year. Back in mid-2018, bond yields started rallying after the US hinted at more aggressive rate hikes due to rapid growth and rising inflation. Even as the US bond yields crossed the 3% mark, Indian bond yields crossed the 7.5% mark and eventually peaked at around 8.3% in October 2018. This not only marked the peak of the liquidity crisis in India but also a reaction to a sharply lower rupee which had gone as low as 75/$. In the middle of all this, two consecutive rate hikes by the RBI only worsened matters for bond yields in India. Since October, yields have been steadily down.
Rate cut expectations
There are 2 levels of rate expectations for the bond markets. While the first one pertains to expectations from the US Fed, the second pertains to RBI expectations. The CME FEDWATCH indicates a 100% probability of a rate cut when the Fed meets on July 31st. But what is more surprising is that there is almost a 50% probability that the Fed would cut the Fed rates by 50 bps from the current level of 2.25-2.50% to a level of 1.75-2.00%. That would be the kind of rate cut that would have been almost inconceivable even 3 months ago. If the Fed obliges with a 50 bps cut, it is being estimated that the RBI may follow suit with a 50 bps rate cut. This would result in a net reduction of 75 basis points in rates since June 2018 and would be really meaningful for pushing growth higher.
But, growth is the real worry
We cannot miss the irony of the situation here. Normally, it is the rates that lead the yields. What we are currently seeing in the Indian economy and the global economy is the falling yields leading monetary policy. And that is not a very good sign. When yields fall ahead of monetary policy, it is a case of low growth expectations dragging the rates lower. That is phenomenon we are seeing globally. That is not an occasion to celebrate falling rates. It is actually a time to be cautious! ©