Aside from the bloodbath in the equity market, Indian bond markets too seem to have caught the bug, with the yield on 10-year government bond spiking over the past few days. On Friday, even as the Indian equity market hit the lower circuit, yield on 10-year G-Sec went up by 10 bps. This is despite widespread expectations of a rate cut by the RBI and CPI inflation in February moving down by a tidy one percentage vis-à-vis the January reading.

What is worrying the bond market?

With WHO declaring COVID-19 a pandemic and economic growth expected to take a sharp hit, monetary and fiscal easing have been on the cards. While the RBI cutting rates further is good news for bond markets, the market appears more worried over the quantum of slippage in fiscal deficit. A sharp rise in Central and State borrowings can lead to oversupply of bonds, which against a weak demand scenario, spells trouble for Indian bond markets.

Short-lived rally

Since the beginning of this year, 10-year bond yields have been gradually declining, with the fall widening after the RBI announced the Long Term Repo Operations (LTROs) in its February policy. On Monday, both global and Indian bond markets saw a sharp rally in prices (yields plunging) as the impact of COVID-19 on growth appeared to exacerbate, fuelling expectations of continued monetary policy easing across the globe.

However on Thursday, bond yields in the euro zone spiked as Christine Lagarde, President of the European Central Bank failed to deliver on expectations of a rate cut. The move rattled investors, as it followed the emergency rate cut by the US Fed last week and the more recent cut by the Bank of England. The ECB’s move and the fact that the US market has already priced in a near-zero rate scenario, only indicate the limited firepower with central banks globally on the monetary policy front to revive growth.

Hence, the onus of reviving growth increasingly rests on the fiscal policies of various governments ― the ECB president has also stressed the need for a coordinated fiscal stance to support growth.

India no different

The Indian story is no different. With the RBI’s repo rate at 5.15 per cent and inflation hovering around the 7 per cent mark over the past two months, there has been limited scope to cut rates further. The February inflation coming down notably to 6.6 per cent levels from 7.6 per cent in January has opened up some headroom for the RBI to cut rates given the weak growth outlook.

However, with the Indian bond market already pricing in another 50 bps rate cut, bond yields may not fall hereon. Also, like in the case of global central banks, RBI has limited monetary headroom by way of rate cuts. Real interest rates in India (nominal less inflation) have been in the negative zone for a while now and unless inflation falls sharply, RBI may not have much leeway to cut rates further.

All eyes on fiscal deficit

Much like in other countries, all eyes are on the government to boost growth. In India in particular, the ambitious disinvestment plan put out by the Centre has increasingly come under a cloud given the weak market conditions. The fiscal deficit target set for FY21 that relies heavily on the Centre’s whopping ₹2.1-lakh crore of disinvestment target is likely to slip sharply. With the Centre’s estimated gross borrowings figure of ₹7.8-lakh crore for FY21 already understated, oversupply of bonds in the second half of the year can lead to upward pressure on bond yields.

The 10-year G-Sec bond yield’s quick and sharp spike to 6.3 per cent levels on Friday from 6 per cent on Monday, appears to factor in the shifting focus on fiscal stimulus and limited firepower with the RBI to support growth hereon.

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