Bond markets that had heaved a sigh of relief post the Budget when the Finance Minister opted for a prudent fiscal policy, has now taken it on the chin with the RBI keeping policy rates unchanged.

But this alone does not explain the sharp jump of about 30 basis points in 10-year G-Sec yields, post the monetary policy. While the RBI did disappoint the market, by maintaining status quo on rates, it was the near-zero possibility of further rate cuts, subtly indicated by the central bank, that spooked bond markets.

With the end of the rate-easing cycle that began in 2015 clearly in sight, bond yields are likely to harden from here on. The possibility of the US Fed turning aggressive with its rate hikes and the RBI not conducting OMOs — buying of government bonds — at the same pace as last year, can also lead to domestic yields moving up. This is also in line with the past trend. The yield on G-Sec has now moved 50 bps above the repo rate (6.25 per cent) — at which banks borrow short-term funds from the RBI.

Bond yields moving above the repo rate in the past has been an indication of rates going up. While a rate hike by the RBI is unlikely at this juncture, if inflation moves up significantly beyond the RBI’s baseline projection, rate hikes could well be on the cards over the medium term.

Past trends

Markets have always been more about expectations. In the past, increasing expectations of a rate cut or hike has led to bond yields moving ahead of the RBI’s policy rate.

For instance, at the end of the rate-hike cycle in July 2008, the yield on G-Sec fell below the then prevailing 9 per cent repo rate. From August to December 2008, the yield was consistently 30-50 bps lower than the benchmark rate. Between July 2008 and April 2009, policy rates were reduced from 9 per cent to 4.75 per cent.

During the rate-hike cycle that lasted from January 2010 to October 2011, when the RBI cumulatively raised the policy repo rate by a total of 375 bps, the bond yields had started to move higher than the repo rate from the middle of 2009 itself.

More recently, the RBI’s move to provide ample liquidity through more OMOs since April 2016, helped suck out the excess supply of government bonds, leading to bond prices moving up and yields lower. Post demonetisation, surplus liquidity and higher demand for G-Sec by public sector banks pushed yields down, narrowing the spread between G-Sec yield and repo rate to 10-20 basis points.

With further rate cuts by the RBI now under a cloud, the G-Sec yield has moved 50 bps higher than the repo rate.

Bond investors should stay clear of duration calls (betting on rate movements) and instead invest a chunk of their debt fund investments in short term income funds that carry less volatility in returns.

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