InvestorQ : Why are the bond yields falling so sharply and what do falling bond yields in India indicate?
Mahima Roy made post

Why are the bond yields falling so sharply and what do falling bond yields in India indicate?

Aditi Sharma answered.
2 years ago

You are right that the fall in bond yields has been very intense in the month of July 2019. In fact, during the third week of July, the 10 year benchmark bond yields touched a 20-month low of 6.25% on Thursday. This level is special because the last time these levels of yields were seen was in the last quarter of 2017; a full 20 months ago. In fact, the fall has been really rapid after it breached the 7% mark. Deutsche Bank research has pegged Indian benchmark yields as closer to 5.5% by next year.

Let us first look at how bond yields have moved in the last couple of years and why this sharp fall is so relevant. Bond yields have been largely a function of the rate direction set by the RBI as well as the liquidity available in the system. Bond yields tend to taper when there is substantial liquidity in the system as we got to saw during the aftermath of the demonetization in November 2016. What is also surprising in the recent past is that the spread between the bond yields and the repo rate are also compressing closer to zero.

Back in mid-2018, bond yields started rallying after the US hinted at more aggressive rate hikes due to rapid growth and rising inflation. US bond yields crossed the 3% mark and Indian bond yields crossed the 7.5% mark and eventually peaked at around 8.3% in October 2018, which was largely helped by the RBI hiking rates by 50 bps in June 2018 and again in August 2018. This not only marked the peak of the liquidity crisis in India but also a reaction to a sharply lower rupee which had gone as low as 75/$. Since October 2018, yields have been steadily down.

Bond yields are also being driven lower by the expectations of a rate cut in the US and also in India. There are 2 levels of rate expectations for the bond markets. While the first one pertains to expectations from the US Fed, the second pertains to RBI expectations. The CME FEDWATCH indicates a 100% probability of a rate cut when the Fed meets on July 31st. The FEDWATCH is a tool by the Chicago Mercantile Exchange which is used to measure the probability of a Fed Rate cut implied in the Fed Futures and is calculated on a real time basis. Today, there is almost a 50% probability that the Fed would cut the rates by 50 bps from the current level of 2.25-2.50% to a level of 1.75-2.00%. That would be the kind of rate cut that was almost inconceivable even 3 months ago. If the Fed obliges with a 50 bps cut, it is being estimated that the RBI may follow suit with a 50 bps rate cut. This would result in a net reduction of 75 basis points in rates since June 2018 and would be really meaningful for pushing growth higher by pushing yields lower.

One thing you also need to understand is that falling yields at a rapid pace could also be indicating at a weakness in growth with a recession like situation. That is already being indicated in negative yield curve in the US. Normally, it is the rates that lead the yields. What we are currently seeing in the Indian economy and the global economy is the falling yields leading monetary policy. That is not a very good sign. When yields fall ahead of monetary policy, it is a case of low growth expectations dragging the rates lower. That is not an occasion to celebrate but it is an occasion to be cautious of falling interest rates. It could be indicative of a deeper risk of an economic slowdown, which is what we need to be wary about.