Why The Bond Markets Sent In A Silent Note Of Dissent On Rajan’s Rate Policy

Towards the last few months of Raghuram Rajan’s tenure as Reserve Bank of India (RBI) chief, the bond markets were sending him a quiet note of dissent. After his last, reluctant cut in repo rates in April, he skipped further cuts in his June and August monetary policies, obviously because retail inflation was trending higher, crossing the 6 percent mark in July.

But consider what the bond markets were up to all this time. From a peak of 7.8 percent in February 2016, the 10-year benchmark government of India bond has been falling in a sustained manner, and now stands just above 7 percent. At the latest government bond auction, the new 10-year GOI saw a cutoff yield of 6.97 percent, clearly below 7 percent.

On the retail side, the vibrant tax-free bonds market, is also showing the same trend. The NHAI 8.75 percent tax-free bond 2029 looked set to fall below a 6 percent yield-to-maturity, clocking 6.06 percent on Tuesday morning trades. If the main government bond markets remain below 7 percent, the long-term tax-free bond markets will tumble too. Tax-free bonds are issued only by government companies, and thus mirror the risk-free status of government of India bonds to a large extent.

Do the bonds markets know something that Rajan didn’t? One reason why bond markets and governors view the future of inflation differently is simple: the markets look ahead through the windshield and what may be coming; the RBI looks more at the rearview mirror, at data points that will support his thesis for a rate cut (or increase or status quo). Clearly, therefore, the bond markets have a different view from that of the governor who just hung his boots.

There can be several explanations for why the bond markets continuously brought down yields when the central bank was more cautious.

One, the markets could have had a more benign view of medium-term inflation than the central bank, possibly looking at a food price fall after a normal monsoon.

Two, they expect demand for credit to remain low, a fact that remains true at this point. In the financial year to mid-August, bank credit to the commercial sector was static, growing by a minuscule 0.1 percent between March and 19 August.

Three, since banks define the bond market (they are the main buyers and sellers), it could also mean that safe government bonds are a better bet than lending to companies, when capital is not available at a good price. This is especially true for public sector banks, which have huge bad loans and badly need higher dollops of capital before they can lend again in a big way.

Four, there may be a broader flight to safety in government bonds, as global factors are now looking worse than before. The US Fed hems and haws over a rate hike; the European Central Bank has been working the printing presses to print more euros to get growth up (one estimate is that it has printed more than 3,000 euros for every man, woman and child in the EU). The EU is clearly in trouble after Brexit, with the markets wondering if Italy will be the next domino to fall. Japan’s Shinzo Abe is said to be plotting another stimulus package, and the world’s biggest hedge fund is predicting a banking bust in China, which means more money will be printed to recapitalise its banking system.

What we are seeing everywhere except India is a burst of reckless monetary policies and wayward government actions. In this scenario, India is the last man standing, with sensible monetary and fiscal policies being pursued. But in a world making money cheaper and cheaper, Indian interest rates clearly cannot sustain. We are not an island.

If banks bid for 10-year paper at 6.97 percent when deposit rates for terms above one year are in the 7-7.5 percent rates (64 percent of bank deposits in fixed deposits), there is no way they can be making a spread on government paper. They will be losing money.

But banks are not foolish. They obviously will bring deposit rates down and expect the RBI to cut rates too, willy-nilly.

More than the level of retail interest rates, which the RBI is fixated on, the bond markets seem to have many more reasons to think rates should be trending down.

Banks, of course, have an interest in lower bond yields. When bond yields fall, they can make a killing as their existing stocks of bonds rise in price, giving them capital gains that can be used to bolster profits.

The bond markets are telling a story different from the RBI, and it is worth listening to them. They can do what governors hesitate to. It’s time for Urjit Patel, the new Governor, to listen to what the bond markets are saying, and not just what the CPI numbers tell.

However, it is difficult to expect a new Governor, who is still to establish his credibility, to cut rates in his very first credit policy. Our best bet would be to expect one in November or December, which will also bring corroboration on a downtrend in cereal prices.