By Invitation. US election spikes up global bond yields

Over the last few months, volatility in global bond markets has intensified as market themes have continued to change. The trend of “low for longer” in yields has been an underlying theme for a while as central banks have sought to counter weakness in demand and subdued inflationary pressures through aggressive monetary policy actions.

Trending down This has taken multiple forms over the years from multiple rounds of quantitative easing, forward guidance, maintaining lower rates over a defined time frame and also until attainment of employment targets to the more recent yield curve-targeting.

This trend has intensified post the ‘Brexit’ vote in June with global bond yields testing new lows after the event as initial market expectations converged towards additional monetary easing. This got manifested in the 10-year Treasury yield touching lows of around 1.35 per cent and most other developed market bond yields trading at negative yields. An emerging new theme of “low forever” however was short-lived as markets started to question the incremental effectiveness of further monetary policy experimentations, which had played a large part in stabilising the financial system in the immediate aftermath of the sub-prime crisis as well as the Euro Zone sovereign debt crisis later.

The emerging new theme of fiscal response to counter the damaging effects of deflation and subdued demand has been the subtle underlying factor playing out recently. The trend of rising global bond yields and curve steepening, especially in the US, had been a pre-election phenomenon as market-based measures of inflation, such as the 10-year break-even rates, have seen a rising trend, with yields moving up by around 30bps (basis points).

Moving up The recent surprise election result in the US has reinforced the expectation of higher fiscal support for demand revival in future. There had also been comments during the campaign criticising the lower interest rate policies of the Fed.

With the Republican party controlling both the houses of Congress along with the White House, the prospect of the promise of higher fiscal spending being implemented has emerged.

At the same time, any trade protectionism, if implemented, may lead to higher inflation in the US over time.

Fiscal support measures, even though they may be growth supportive, could lead to an expansion of public debt. In this context, the market which had got used to a glacial rate of policy adjustment could look at a scenario where the Fed policy rates could move up earlier than expected. These fears have resulted in 10-year Treasury yields moving higher to around 2.30 per cent, which has been accompanied by a stronger dollar.

Indian bond market The rising Treasury yields have left Indian bonds unaffected as the market dynamics have been overwhelmed by the announcement on cancellation of the legal tender of high-denomination currency notes. In the very short term, accretion of deposits along with restriction on withdrawals has led to good demand for SLR (statutory liquidity ratio) securities.

In the long term, the expected additional deposit mobilisation could lead to better financial inclusion, easier liquidity as well as better transmission of policy cuts. As regards the near-term inflation outlook, the exercise has the effect of a monetary shock in a largely cash-based economy, with around 85 per cent of the currency in circulation being impacted in the near term.

Overall, given the linkages between the formal and informal economy, in the near term, economic activity could be impacted which the RBI/MPC (Monetary Policy Committee) would take note of.

The long-term positive impact on government finances of a shift to formal economy is another positive factor that has contributed to the current divergence.

Even as our bond markets are largely domestic-based in terms of investors and demand, the growing inter-linkages with global markets cannot be ignored. While FPI ownership may be low, there could be a feedback loop that emerges from the impact of a strong dollar and higher US Treasury yield on the currency and its impact on capital flows. In the near term, the domestic positives have been predominant.

Incrementally, as clarity emerges regarding the net impact of the cancellation of legal tender status of high-denomination notes, accompanied by the trend in global rates, one could witness phases of volatility.

The writer is Head Fixed Income, SBI MF

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