The fortunes of the bond market have often rested on how international oil prices move. So with crude oil prices surging to break key levels, bond traders here have begun discarding their holdings with gusto.
Bond yields rose 30 basis points in the last two months to touch a six-month high and traders are convinced this is not the peak. After all, the word on the Street is that crude oil prices would continue to rise further. A basis point is 0.01%.
Brent crude has been rising steadily over the past six months and has topped $62 per barrel, more than two-year high. This is as good as a death knell for future policy rate cuts and removes even a sliver of a chance for one, as the Reserve Bank of India (RBI) is unbending on its inflation commitment. Analysts estimate that a $10 per barrel rise in crude oil price pushes up the Wholesale Price Index-based inflation by as much as 1.5 percentage points. The trickle-down effect on retail inflation will be enough to put the central bank off any rate cuts.
That is not all. The rise in international oil prices widens the country’s current account deficit, making the rupee vulnerable to depreciation and adding further fuel to the inflation fire through imported inflation. Fuel inflation has a bearing on almost every other commodity and especially on core inflation, RBI’s constant bugbear.
If this wasn’t enough, a potential fiscal slippage by the central government and states going rogue on fiscal prudence queer the pitch on policy rates even more.
But these are negatives that have been a regular affair in the past and are characteristic of a rising interest rate scenario. What is new this time around is that RBI has been one of the biggest sellers of bonds. It has sold Rs40,000 crore through open market operations since September and a total of Rs70,000 crore so far in the current fiscal year.
This was the kick in the teeth for the bond market.
Between all these negatives, bond investors are running out of reason to add to their holdings. The abundance in the banking system’s liquidity is doing little to support the market and this surplus is on its way out as well. The surplus is now down to Rs1.5 trillion from as high as Rs4 trillion in the aftermath of demonetization last year. Since the central bank is a big seller of bonds (to sterilize liquidity), why shouldn’t the rest of the market follow?
So, who is the first one running out of the market? Data from the Clearing Corporation of India Ltd shows that foreign banks were the biggest sellers and offloaded close to Rs40,000 crore worth of bonds between September and now. Mutual funds sold about Rs10,000 crore during the same period. Others may soon join once credit offtake begins to pick up.