Monday was a turbulent day for the bond markets, with crude prices taking a sharp plunge to $35 a barrel levels (brent crude). With growing concerns over the spread of the coronavirus depressing the demand prospects of oil and the no-deal among the members of the OPEC (Russia refusing to accept the OPEC’s proposed production cuts), there was pandemonium in the oil markets, which spilled over into equity and bond markets. With widespread fears over global recession now intensifying, investors are exiting stocks and flocking to safer government bonds.

The fallout? The yield on US 10-year government bond falling to record lows of 0.32 per cent during the day (yield and price are inversely related), and closing at 0.46 per cent (down from 1.5 per cent levels just a month ago). In India, the 10-year G-Sec slipped below the 6 per cent mark briefly and closed at 6.05 per cent (down from 6.4 per cent levels a month back).

Will bond yields continue to plunge?

US bonds rally

Over the past month or so, flows into global bond markets, including India, had increased, owing to the fallout of the coronavirus.

Last week, US Federal Reserve Chairman Jerome Powell surprised markets with an emergency rate cut of 50 bps to 1 to 1.25 per cent, with the coronavirus posing evolving risks to economic activity, according to the FOMC statement. There are expectations that the US Fed will cut rates once again in the upcoming policy next week and that policy rates could near zero in the coming months.

This has fuelled the sharp bond rally with yield on 10-year US bond appearing to breach the 0 per cent level soon.

But while there is now growing concern that the coronavirus fallout will be longer, a sharp fall in bond yield here on is unlikely. With the market already pricing in a near-zero rate scenario, there is not much scope for a steep fall in yields. In fact, yields could spike, as they did in 2008, as fiscal stimulus is rolled out in the coming months.

Indian bonds upbeat

With the US Fed cutting rates unexpectedly, there have been hopes that the RBI will also cut its policy rate soon before the upcoming policy in April. While increasing inflation and fiscal deficit worries were expected to keep the RBI in a long pause mode, the events of the past week have re-kindled hopes of a sharp cut in the repo rate.

In January, the CPI inflation had inched up to 7.59 per cent levels, the highest since July 2014. What was of particular concern was that the rise in inflation was becoming more broad-based. Fuel inflation had also inched up to 3.7 per cent.

But with crude prices on a slippery slope, there could be some respite on the overall headline CPI inflation. Of course, the bigger factor that could drive the RBI to slash rates is the worsening slowdown. Toeing the line of other central banks, the RBI may cut its policy rate further. But how much more can 10-year bond yields fall here on?

Short-lived rally?

The repo rate is currently at 5.15 per cent. Over the past month, despite the RBI holding rates in the February policy, 10-year G-Sec yield fell about 15-20 bps to 6.3 per cent levels, mainly on account of the RBI announcing (in its February policy) Long Term Repo Operations (LTROs) for one-year and three-year tenors amounting to ₹1-lakh crore.

In Monday’s bonds rally, yields fell further to 6 per cent levels. This already factors in further rate cuts by the RBI. From here on, the fall in yield is unlikely to be substantial, as worries over fiscal deficit will start to hog the limelight again. Remember, as growth in the economy continues to falter, the Centre will have to undertake fiscal stimulus measures to revive growth. With the estimated Centre gross borrowings figure of ₹7.8-lakh crore for FY21 already understated, oversupply of bonds in the second half of the year will limit the downside in bond yields.

Further, a lot will depend on the demand from foreign investors. Through 2019, demand from foreign investors in Indian bonds was tepid. As of March 9, FPIs have utilised only 49 per cent limits in government bonds and 56 per cent in corporate bonds. There has been a net outflow of ₹13,581 crore from Indian debt so far this year.

The 10-year government bonds in India today offer a yield of about 6 per cent on a nominal basis. But with CPI inflation moving past the 7 per cent mark, real interest rates (nominal less inflation) have turned negative. If the RBI cuts rates further, real rates could shrink further unless inflation falls sharply. On a nominal basis, Indonesia offers 7 per cent on its 10-year bond. Indonesia’s inflation is currently at about 3 per cent, which implies a tidy 4 per cent of real interest rate.

Hence demand from FPIs into Indian bonds could remain tepid. Investors should remain cautious and not buy into the current bond rally aggressively.

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