The Indian version of yield-curve conundrum

Alan Greenspan coined a term called ‘yield curve conundrum’ to describe what he thought was an anomaly in the US treasury market then. As the Federal Reserve with Greenspan at the helm of affairs kept raising the Fed rate, long term rates ironically kept low resulting in a flat to inverted yield curve. The impending slowdown in US was one key fundamental reason for the long term rates to remain relatively low. Yet, the generic long term demand for US treasuries by global central banks and long term liability managers kept the long term rates subdued despite the increasing inflationary pressures in the economy. For a period too long, the long term rates seemed to react to anything but events and policies mushrooming in US.

A similar conundrum, albeit differently, is what we are experiencing in the Indian bond market for some time now. Reacting to a domestic slowdown resulting in contraction of output and falling prices, the Reserve Bank of India has rightly been easing its monetary clutches in the economy by cutting all rates it could – CRR, Repo, Reverse Repo and SLR. Though the central bank embarked on the easing during mid-2008, it intensified the rate cuts towards the end of CY2008. After an initial logical fall in the long term yields, we have experienced a reversal in the trend during the last few weeks starting mid-January 2009. The key reason for this conundrum is the supply of long term bonds to fund the accumulating fiscal deficit. An already fragile bond market has depicted its non-willingness to keep absorbing higher supply without paying lesser price for them. Yield, henceforth, have been moving northwards. With the supply calendar looking to increase with coming months, where are we headed in terms of interest rates in the system?

For one, RBI will continue to ease benchmark policy rates against a very comfortable backdrop of near-zero WPI based inflation and contracting industrial output. Considering the most likely scenario of WPI inflation remaining at an average of -1% from now to the end of FY2010 (conservative estimate), and a real interest rate of not more than 2%-3% to tackle an extremely subdued growth outlook, the nominal benchmark rates will have to be cut to levels of 2% or less quite soon. With liquidity conditions expected to keep positive on a consistent basis through CRR cuts/OMO by RBI, the effective benchmark policy rate would continue to be the Reverse Repo rate. Thus one could expect at least 150bps of easing over the next few months.

Secondly, yields would be supported by comfortable liquidity in the money market. Fiscal spending, OMO and possible cuts in CRR will help the liquidity remain the positive regime over the next many months. It seems very unlikely that bonds would be sold to create liquidity for meeting credit demands in the economy.

Thirdly, generic demand from insurance companies, banks, mutual funds, and importantly FIIs will help absorb the incremental demand in FY2010. With rupee trading at 50-plus levels against US Dollar in the exchange market, a comfortable stance by the RBI to help currency appreciation will favour the foreign investors chasing risk free yields in the uncertain global investment regime. It seems highly likely that RBI will intervene more aggressively starting April to push USD/INR rates lower after FII buying into bonds. Weakening USD globally (backed by huge monetization of deficit by US government) and revival in investment flows will help the rupee appreciation cause too in favour of investing FIIs.

Fourthly, RBI’s holdings in outstanding government bonds have been steadily rising over the last 12 months. This trend will most likely continue and rather intensify as we move ahead. RBI’s holdings as a percentage of total outstanding has steadily increased from 4.3% as at December 2007 to 5.8% as at the end of September 2008.

Despite a heave supply side pressure on yields, it still looks likely that the long term yields would ease in the coming months responding to a temporary statistics-induced deflation and easing benchmark rates.

As a probable move in the near term, RBI could consider introducing a ceiling on the Reverse Repo absorptions under LAF to effectively bring in a zero interest rate policy without officially cutting interest rates. Subdued money market rates will help the yields ease helping the cause of broader interest rate regime in the economy.

We will have to wait for the April policy to see if RBI might want to embark on a dynamic path like this to manage the monetary objectives.