India's 10-year government bond yield serves as a crucial benchmark for interest rates across the debt market. Among various bonds traded in the country, this particular security attracts the most attention from investors and policymakers alike. Since June, its yield has persistently remained within a narrow range of 6.40% to 6.60%. This stubbornness persists even as the Reserve Bank of India has been actively lowering its repo rate, a move that typically pulls bond yields downward.
The Ripple Effect Beyond Government Securities
This divergence would matter less if it stayed confined to government securities. However, bond yields for state governments and corporations are benchmarked against what G-Secs offer. These entities must price their bonds with a spread above G-Sec rates as a risk premium. Consequently, states now lament that their borrowing costs have increased significantly. Corporations too face higher interest rates, creating a peculiar situation where bank loans have become cheaper while bond markets remain expensive.
Banks Caught in Regulatory Crosscurrents
Banks face their own challenges in this environment. When the RBI lowers the repo rate, banks must reduce their lending rates because many loans are directly linked to repo movements through India's unique external benchmark lending rate system. This mechanism aims to ensure swift policy transmission. To protect their margins, banks then lower deposit rates, which in turn reduces the basic component for calculating the marginal cost lending rate.
Yet the market operates through decisions by various players including banks, mutual funds, insurance companies, and primary dealers. While banks, as major G-Sec market participants, lower rates in response to regulatory requirements, the broader market doesn't always accept these lower rates.
Why Bond Yields Remain Stubborn
Several factors contribute to persistent bond yields. The government's increased borrowing program has raised the supply of G-Secs, which typically lowers prices and raises yields. The RBI, acting as the government's debt manager, has indicated that central borrowing won't exceed budgeted amounts, with similar constraints applying to states.
The tight liquidity situation compounds these challenges. Weak deposit growth as interest rates drop has created liquidity shortfalls that required RBI intervention. The central bank has taken multiple measures to assuage yields indirectly, including cutting banks' cash reserve ratio and conducting open-market G-Sec purchases to inject liquidity.
A Curious Market Response
Interestingly, bond yields actually rose after RBI's June policy announcement, when the central bank suggested limits to how much the repo rate could be cut to support economic growth. The 10-year G-Sec yield climbed from 6.26% before that policy to 6.40% by August's announcement, then to 6.50% in October. Since then, it has hovered around 6.60%, establishing what appears to be a new normal.
December's policy included a repo rate cut alongside bond buyback announcements and hints at possible future reductions. However, the market may have interpreted bond purchases as primarily aimed at providing liquidity rather than directly influencing yields, potentially signaling acceptance of the prevailing yield range.
Alternative Interpretations and Policy Implications
Looking at the situation differently, steady yields in the 6.50-6.60% range might indicate this represents a fair market level. This interpretation suggests that trying to force yields lower might prove difficult given how market forces have established this equilibrium. It could imply that June's 5.5% repo rate was consistent with macroeconomic stability, potentially making December's cut unnecessary.
India's current Goldilocks scenario of high growth and low inflation complicates policy interpretation. Following December's logic of cutting rates to support growth, there might be cases for further reductions in February and April, especially with GDP growth expected to fall below 7% while inflation remains within RBI's target band. The question becomes how much further rates can realistically be lowered.
The Market's Voice Through Bond Movements
Bond yields theoretically price in all available information about growth, inflation, fiscal conditions, liquidity supply, and other factors. Their steadiness over the past six months could be interpreted as market endorsement of the current yield range. If this interpretation holds, a 5.5% repo rate would be ideal, creating approximately a 100 basis point spread for the 10-year G-Sec.
Bond yields could serve as important signals for setting repo rates if one accepts that efficient market principles are at work. This raises an intriguing question about whether the 10-year bond yield could function as an indicator for monetary policy, especially as India's financial conditions depart from conventional patterns.
These perspectives offer food for thought as markets and policymakers navigate complex economic terrain.
