Market pandits have got the movement in bond yields wrong for the last three months. Yields were expected to go up due to higher borrowing programmes of the central and state governments, a rise in global yields and expectation of higher CPI inflation in the coming months. The Bloomberg Commodity Index has reached the highest levels in last 10 years.
In the Indian context, the second wave of Covid has led to severe strain on the public healthcare system. This second wave has impacted the rural hinterland and the urban middle class, unlike the previous wave which had affected mostly the urban centres. Selective lockdown imposed by industrial states has led to unemployment levels rising to 10.7 % in April and is expected to be around 15% by the end of May (CMIE Data).
The number of people below the poverty line has increased from 6 crore to 13.4 crore due to Covid (Pew Research ). The middle class has shrunk by 3.2 crore due to the pandemic (Pew Research). Most SMEs have seen sales drop by 15-30% and wages have degrown 20-30% in most SMEs.
The number of people employed in the formal sector has come down from 2019 and informal sector, which are low paying jobs have increased. The government debt-to-GDP ratio has increased to 85% of GDP. Fiscal room for spending was restricted due to chance of downgrade in sovereign rating.
RBI had to do the heavy lifting of the economy. Space for conventional monetary policy measures is limited as reverse repo rate is at 3.35% and real interest rates ( operating rate minus expected one year CPI inflation) is negative. RBI is bound by CPI inflation target of 2-6 % set by Parliament. RBI resorted to unconventional monetary policy by first announcing GSAP 1 (Government Securities Acquisition Programme) of Rs 1 Lakh crore for the April-June quarter with a promise to do GSAP 2 in the coming quarters.
The RBI Governor said this GSAP 1 is over and above the normal OMO and Operation Twist announced. RBI has started buying government securities in the secondary market, whenever yields have gone above the primary market levels auction levels, giving comfort to market players, who are buying in primary auction. RBI has bought around Rs 35,000 crore in the secondary market to bring down the overall yield curve. RBI is not allowing the 10-year yield to go above 6% level.
Government cash balance is comfortable due to the balance carried forward from last year. The government and RBI have cancelled auctions when the market players demanded higher yields in the primary auction. This is applicable across the yield curve. The government and RBI are comfortable with the three-year G-sec yields remaining below 5%, 5-year yields below 5.65% , 10-year around 6%, 15-year below 6.65% and 40-year yield around 6.90% levels. Beyond which, we have seen RBI cancelling auctions or announcing OMO/Operation Twist/ GSAP to bring down the yield curve. RBI in its OMO, GSAP has bought the benchmark auction paper at 5 basis points lower than the prevailing market yields . These actions by RBI and the government have helped stabilise the G-Sec yield curve, which is lower than what was prevailing in March 2021.
Corporate bond yields spread has now come to 10 to 30 basis points over G-Sec for PSU papers, and 30 to 40 basis points for ‘AAA’ non-PSU papers. The spread contraction has been due to reduced supply of corporate papers in the market and excess liquidity of Rs 5 lakh in the system. Bank credit growth has been muted with year on year credit growth below 6% levels. Most banks, including PSU banks like SBI have started investing in corporate papers due to lack of deployment avenues.
Corporates are not utilising their sanctioned limits fully due to the lockdown restriction. Given the effect of the pandemic on the balance sheets of corporates and individuals, banks are expected to be cautious while lending to lower rated Cibil scores for individuals.
The global economy is recovering due to vaccination drive in advanced economies, 40% of the population being vaccinated in the US. This has led to increase to increased demand and increase in overall price levels as supply restrictions are still prevailing in different parts of the world. As these restrictions are removed with vaccination of the population, the supply response should see prices remaining stable or coming down. However, in the Indian context, when the lockdown is lifted there could be a surge in demand.
RBI may then have to reduce the amount of liquidity in the banking system to control inflation pressure. This development may constraint RBI from doing GSAP, OMO, Operation Twist to the same extent to which they are doing now. RBI has done Rs 1.05 lakh crore of GSAP, OMO, secondary market purchases against the government borrowing of Rs 2.08 lakh crore till May 27, 2021. This has kept the 10-year yields around 6% levels as RBI has bought half the amount of auctioned papers.
Government bond yields are expected to drift higher in the secondary half when bank credit picks up and banks look for profitable investment for growing their balance sheet.