Your Money: Considerable volatility in bond market likely in next 6-9 months
As growth picks up and inflation rages, the central bank in India and around the world will not only raise interest rates, but also reduce liquidity support to bond markets.
By Pankaj Pathak
Indian bond markets have been pampered for the past three years by the incredible actions of the central bank. The Reserve Bank of India (RBI) cut interest rates, eased liquidity, and bought record amounts of government bonds to anchor market interest rates to low levels.
As growth picks up and inflation rages, the central bank in India and around the world will not only raise interest rates, but also reduce liquidity support to bond markets. The possible divergence in the timing, scope and pace of actions will be the main driver for bond markets in 2022. Misunderstandings are likely to creep into this symbiotic relationship. Confidence will be paramount. Divergent views will lead to volatility.
We expect considerable volatility in the Indian bond market over the next six to nine months due to:
a) Divergence of the RBI’s actions and its expectations on the bond market
b) Divergence in the actions of the US Fed and its expectations on global asset markets
c) Divergence in the exit policies of central bankers across the world impacting asset prices and flows to India.
Divergence on the assessment of inflation
In India, consumer price inflation (CPI) has averaged 5.96% over the past 24 months (December 2019-November 2021) compared to an average of 4.1% over the previous five years (December 2014-November 2019). Although the last three readings of headline CPI inflation were between 4% and 5% (4.35%, 4.48% and 4.91% in September, October and November 2021, respectively), this was largely due to the base effect of a high CPI reading over the same period. months of last year (7.27%, 7.61% and 6.93% respectively in September, October and November 2020).
Much of this distortion of the inflation figures has been caused by a sharp rise and fall in the prices of vegetables. Inflation excluding vegetables, which constitutes around 94% of the CPI basket, has been between 6.64% and 6.87% over the past three months; and for the past 12 months it was on average 6.4%. This is not only significantly higher than the RBI inflation target of 4%, it also remains above the RBI inflation tolerance band of 2% to 6%.
India in the world of uncertainty
Monetary tightening (cash withdrawals and rate hikes) in the developed world typically causes capital outflows from emerging markets (EM) and puts pressure on EM currencies and bonds. Emerging countries with low / negative real interest rates (interest rate minus inflation rate), high debt levels and extensive fiscal and current account balances are more vulnerable.
Divergent yield curve
Since the start of 2021, bond yields have already risen significantly, pending a tightening of liquidity and possible rate hikes. Thus, gradual and well communicated rate increases will be absorbed comfortably. However, we may continue to see a gradual increase in short-term yields as central banks raise rates and reduce liquidity.
Long-term bond yields may remain limited to current levels or rise only slightly, as we expect this rate hike cycle to be much shallower as the RBI tries to keep the repo rate closer. from 5.0% to 5.5%. Long-term bond yields, however, face the risks of a sudden change in the position of central banks. India faces this risk of rising oil prices or rising food prices. This would force the RBI to raise interest rates sharply and the markets could face higher volatility.
The author is a fund manager, Fixed Income, Quantum Mutual Fund
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