bond yields: we now know where exactly RBI wants bond yields to stay
In the Indian context, the second wave of Covid has put great pressure on the public health system. This second wave impacted the rural hinterland and the urban middle class, unlike the previous wave which mainly affected urban centers. The selective foreclosure imposed by industrial states drove the unemployment rate up 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 fell from 6 crore to 13.4 crore thanks to Covid (Pew Research). The middle class has shrunk by 3.2 crore due to the pandemic (Pew Research). Most SMEs have seen their sales fall by 15-30% and wages by 20-30% in most SMEs.
The number of people employed in the formal sector has decreased compared to 2019 and the informal sector, which are low-paying jobs, has increased. The public debt-to-GDP ratio rose to 85% of GDP. Fiscal room for maneuver for spending was limited due to the risk of a downgrade in the sovereign rating.
RBI had to do the heavy lifting of the economy. The room for maneuver for conventional monetary policy measures is limited because the repo rate is 3.35% and real interest rates (operating rate minus CPI inflation expected over one year) are negative. The RBI is bound by the CPI inflation target of 2-6% set by Parliament. RBI resorted to unconventional monetary policy by first announcing GSAP 1 (Government Securities Acquisition Program) 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 goes beyond the announced OMO and Operation Twist. RBI has started buying government securities in the secondary market whenever yields have exceeded primary market auction levels, which has reassured market participants, who buy at primary auctions. RBI bought around Rs 35,000 crore in the secondary market to lower the overall yield curve. RBI does not allow the 10 year yield to exceed the 6% level.
The government’s cash balance is comfortable due to the balance carried over from last year. The government and the RBI canceled the auctions when market participants demanded higher returns in the primary auction. This is applicable across the entire yield curve. The government and RBI are comfortable with three-year G-sec yields remaining below 5%, 5-year yields below 5.65%, 10-year yields around 6%, 15-year below 6.65% and at age 40 around 6.90% levels. . Beyond that, we have seen RBI cancel auctions or announce OMO / Operation Twist / GSAP to lower the yield curve. RBI in its OMO, GSAP bought the benchmark auction paper at 5 basis points below the prevailing market yields. These RBI and government actions have helped stabilize the G-Sec yield curve, which is lower than what prevailed in March 2021.
The corporate bond yield spread is now 10 to 30 basis points on G-Sec for PSU papers and 30 to 40 basis points for non-“AAA” PSU papers. The contraction in spreads is due to a reduced supply of corporate papers on the market and to excess liquidity of Rs 5 lakh in the system. Bank credit growth has been moderate with annual credit growth of less than 6%. Most banks, including PSU banks like SBI, have started investing in corporate papers due to lack of means of deployment.
Businesses are not making full use of their sanctioned limits due to the lockout restriction. Given the effect of the pandemic on the balance sheets of businesses and individuals, banks should exercise caution while lending to lower rated Cibil ratings for individuals.
The global economy is recovering due to the vaccination campaign in advanced economies, with 40% of the population being vaccinated in the United States. This has led to an increase in demand and an increase in overall price levels, as supply restrictions are still in effect in different parts of the world. As these restrictions are lifted with the vaccination of the population, the supply response should see prices remain stable or fall. However, in the Indian context, once the lockdown is lifted, demand could increase.
RBI may then need to reduce the amount of liquidity in the banking system to control inflationary pressure. This development may prevent RBI from doing GSAP, OMO, Operation Twist to the same extent that they currently do. RBI made Rs 1.05 lakh crore from GSAP, OMO, secondary market purchases against the government loan of Rs 2.08 lakh crore until May 27, 2021. This kept 10 year yields around 6% because RBI bought half the amount of papers auctioned.
Government bond yields are expected to rise in the second half of the year as bank lending picks up and banks look for profitable investments to grow their balance sheets.