After the announcement of the FY22-23 budget, there was a sharp rise in the yields on government bonds with a 10-year maturity. Yields on the bonds surged to almost 6.9%, the highest increase the market has seen since 2019.
Bond yields on government securities act as a barometer of market sentiment and the RBI’s policymaking. The sharp rise in the 10-year yield can be attributed to multiple reasons, of which the primary reason is that the market does not believe in the government’s Budget math.
Oil price assumption
To begin with, the government’s Economic Survey forecasts the price of crude oil to be an average of $70-$75 per barrel throughout the year compared with the current price of a little more than $90 (as of February 8) for a barrel of Brent crude. A higher crude price places more pressure on the country’s import bill and the economy. It also means that a more significant amount of forex reserves will pay for the higher bill on crude oil.
Furthermore, the Reserve Bank of India (RBI) has recently seen a decline in their forex reserves by more than $4.5 billion, the steepest drop in more than a year. The RBI uses its forex reserves comprised of foreign currency assets and foreign asset income to reduce currency volatility to enable the smooth trade of goods and services between India and its trading partners. The RBI’s forex reserves decline can be traced to a higher-than-expected crude price and a drop in foreign investment in Indian securities.
U.S. inflation and Fed
Additionally, another critical reason for the current bond market sentiment has to do with global monetary policymaking.
The U.S. has seen inflation quicken to a 40-year- high of 7.5%, a stark contrast to their average inflation rate of about 2% in the past two decades. The Federal Reserve has promised to tackle inflation by putting an end to the quantitative easing and raising rates.
When a foreign country (especially a financial capital of the world) raises their rates, we will see money flow from Indian markets to theirs. This flow of capital implies that there will be upward pressure on the yields of all bonds, especially the government bonds. A flow of money abroad will also mean that asset prices such as equity see a correction, which puts tremendous pressure on the RBI’s forex reserves.
Moreover, in the recent budget announcement, subsidies for fertilizers were reduced to insufficient levels, with experts predicting an increase in the estimate in further revisions. To put this in context, last year, the government revised its fertilizer subsidy allocation upwards by more than 70%.
A higher-than-expected crude price puts pressure on the import prices of fertilizers.
Market sentiment indicates that the government is likely to overshoot its expenditure estimates and borrow more soon. An increased level of government borrowing is detrimental to an already burdened RBI.
When the government borrows from the market, it causes an effect known as “crowding out”, which means that interest rates become too high for private parties to borrow and invest. Crowding out forestalls economic progress as now businesses find it difficult to borrow at these higher rates.
The RBI will have to step in and control the rising yields, and with a decrease in foreign capital inflows, the burden on the market is even more significant due to the increased borrowing.
A higher interest rate will also mean it becomes more expensive for the average consumer to stimulate the economy through their consumption. Therefore, the economy and growth figures are put under pressure.
Excellent opportunity
All of this means that we have an excellent opportunity to capitalise on as investors. With the global trend of rising interest rates, we should see a price correction in most securities, including equities and bonds, making it a lucrative opportunity for investors to buy at stellar valuations. It is vital to recall a timeless quote by Warren Buffet, where he says, “be greedy when others are fearful, and fearful when others are greedy”.
However, with rising interest rates, it goes without saying that it is prudent to limit borrowing as the actual interest rate burden (nominal interest rate minus rate of retail inflation) is going to be more significant.
We must fasten our seat belts for volatile times, and we must have a reserve of liquid assets both to capitalise on great valuations and as abundant precaution for turbulent times.
(Anand Srinivasan is a consultant. Sashwath Swaminathan is a research associate at Aionion Investment services)
