Posted by: Deepa Vasudevan on Thu, May 31st, 2018
An Unofficial Rate Hike in Financial Markets
An unofficial, market-driven, rate increase is taking place in the financial markets. The policy repo rate has remained unchanged at 6% since August 2017, but bank lending rates and corporate bond yields have climbed up steadily. The upward shift started around September 2017- triggered by concerns of fiscal slippage and built up subsequently by rising crude prices and global sell-offs of emerging market bonds. As yields on the benchmark 10-year g-sec increased, so did yields on corporate paper. While 10-year AAA bonds gained about 1.4% between Jan 17 and May 18; yields on shorter tenor paper (one to five years) increased by much more. Some of this rise simply reflects market expectations of a rate hike in the near future. But at least some of the “unofficial” tightening is the result of recent developments in the bond and forex markets. Portfolio investors sold debt worth $5.7 billion between February and May, and an additional $ 2.3 billion of equity in April and May. These dollar outflows, naturally, led to a drop in the USD/INR exchange rate. The RBI intervened to prevent excessive depreciation by selling dollars and buying rupees, thus reducing domestic rupee liquidity. By mid-May, systemic liquidity at the shorter end had become so tight that 3-yr and 5-yr bond yields were quoting at a premium to the 10-yr yield! This anomaly was corrected only after RBI injected Rs.100 billion through an open market operation of g-secs.
Figure 1: A Snapshot of Interest Rates
In the Second Bi-Monthly Monetary policy on June 6, 2018, the RBI will face tough choices. A rate hike will worsen existing liquidity constraints and increase corporate borrowing rates even more. A rate cut would increase inflationary pressures and reduce the attractiveness of Indian bonds to foreign investors. Usually, a monetary policy meeting wrestles between cutting rates to stimulate growth and increasing rates to control inflation. This time, rising US interest rates, RBI’s forex operations, and bond market conditions have added more complexity to the policy decision.
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 On 18th May, the yield on the 3-yr AAA bond was 8.5%, 5-yr AAA bond was 8.6%, and 10-yr AAA bond was 8.49%.(Source: STCI Weekly bond market update). The 10-yr g-sec benchmark yielded 7.84% while the 5-yr gec yield was 7.85% (Source: CCIL daily market update).
 An open market purchase of g-secs allows RBI to buy g-secs and release durable liquidity into the system. The liquidity is “durable” because it is not reversed after a specific period, as in the case of a repo transaction.