The Hindu Business Line : Markets can be irrational, but not forever

A Bank of England rate hike coupled with an almost certain Fed rate hike in the last week of June worsened the bond market sentiment quite significantly.

A sharp jump in the headline IIP (Index of Industrial Production) for the month of April and increasing pressure from the Left to keep the EPF rate at the current level if not hike it, further eroded market confidence. To make matters worse, unexpectedly the WPI (Wholesale Price Index) inflation jumped sharply by almost fifty basis points last Friday. The jump was on account of a rise in all the three components of the index, manufactured products being the sharpest one.

In the last eight years, I have seen such large falls only in the face of either some geo-political uncertainty or a run on the rupee. This must be the first time that the market has seen such a sharp and sustained fall outside of these two factors.

The thing with bond market uncertainty on account of the two factors mentioned above was that the market stabilised as soon as the cause abated. If it were on account of some geo-political risk, the market would gain strength as soon as the risk reduced. Similarly, as soon as the rupee stabilised, the market always managed to find its feet and continue with its usual habit of going up.

Market participants haven't really seen an interest rate reversal for many years and hence, are used to staying long in the absence of the two factors mentioned above. They might be in for a surprise this time. As I had said in my last column (June 7), a reversal in rates in the country is not only an outcome of economic factors but also political ones. There is no doubt that the economy is growing at a healthy pace and with the impact of the fuel price hike, even inflation shall be ruling at a slightly uncomfortable level.

The domestic economic fundamentals coupled with the global interest rate outlook make it extremely difficult for the RBI to cut rates any further. That is the economic side of the story.

Even the political environment points towards rates drifting up. The Finance Minister's repeated remarks about the need to balance the level of interest rates to suit both the savers and the investors is a clear hint that the interest of the household savers shall be protected.

I have no doubt in my mind that the EPF rate shall not be cut any further and shall be kept at least at 9 per cent which no fund can deliver at the current level of interest rates. So either the rates move up or the Government ends up with a big hole in its Budget; both the scenarios are bad for bonds.

Increasing subsidy and no privatisation is going to add further pressure on Government resources and hence push up its borrowing.

The differential between the 10-year sovereign bond yield and the RBI repo rate has been as low as 30-40 basis points but that was always temporary and on account of huge expectations of a repo rate cut. We saw the differential stabilise at around 60-65 basis points, which by any global standard was extremely low.

The only reason that comes to my mind for such a small differential is the eternal optimism of the market. It always expects the central bank to move rates lower if not immediately, then sometime in the future.

I don't say that the optimism is misplaced but this is the first time when the market is scared of the central bank moving rates the other way, which has caused the spread to increase to almost a 100 basis points.

But the whole increase has been on account of the widening of the 1 cross 5-year spread.

The 5 cross 10-year spread has remained unchanged at almost 30 basis points. So what has happened really is that the 1 cross 5-year and the 10 cross 20-year tenor spreads have widened very sharply without any change whatsoever in the 5 cross 10-year spread.

The 8 cross 10-year spread is actually at a ridiculous level of 4-5 basis points. They say that markets can remain irrational for longer than you can remain solvent, but one forgets that they will not remain irrational forever.

With the 8 cross 10-year spread at 4 basis points and the 10 cross 11-years at 20, the market is being irrational now which it will not be always.

Hope some investors are listening.

(The author is a senior trader, Interest rates at HSBC Mumbai. The views mentioned herein are his own and not necessarily those of his employer.)

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