Who Moved My Interest Rates?

Any investor who has spent reasonable time in financial markets would tend to agree that the narrative can change very quickly as far as asset prices are concerned. Roughly a year back, the world was grappling with the idea of negative interest rates. In fact, in early 2017, close to US$10 trillion worth of global bonds had negative yields. This was unprecedented and led to widespread concerns of deflationary pressures in the global economy. Fast forward to 2018 and the concern has now shifted from NIRP/ZIRP to the recent sharp rise in bond yields. There has been an across the board sell-off in DM bond yields with the US 10-year treasury yield increasing by roughly 80bps since last September.

This brings us to the question – what macro outlook are US treasuries currently pricing in?

In order to explain the behaviour of longer-term rates, it is useful to decompose the yield on a long-term bond into three components: expected inflation, expectations about the future path of real short-term interest rates, and a term premium.  If we look at recent inflationary expectations (using US 10-year breakeven rate as a proxy), we observe that while they have risen, they continue to remain well-anchored around the Fed 2% inflation mandate (Chart 1). In other words, US ten year yields are currently discounting a relatively benign profile for CPI inflation. Thus, inflation expectations cannot be a good explanatory variable for the recent sharp move in US treasuries.

Chart 1: US Bond Yields have risen far more than inflationary expectations

One of the major reasons why bond yields have spiked recently is that markets have finally begun to price a more aggressive Fed. In fact, the market implied Fed policy rate hikes is now closest to the FOMC’s median dot plot than it has ever been since the start of the tightening cycle. The Fed futures rate is now pricing in 3 rate hikes this year as opposed to one hike being priced in at the beginning of the year. Consequently, this adjustment in expectations has led to the recent sell-off in bond markets. Although difficult to measure, there seems to have been a rise in term premium as well. All these years, large scale quantitative easing programs by major Central Banks created an artificial demand for bonds and helped to keep term premiums extremely low (in fact term premiums moved to negative territory). This trend finally seems to be changing. The interplay between a heavier prospective supply of bonds by the US Treasury and the absence of Fed purchases now seems to be finally weighing on long term bond yields.

Going forward, US bonds face two significant headwinds. Firstly, the ongoing trade war can lead to a significant rise in inflation risk premium than what is currently been priced in by the bond markets. In the last two decades, world trade has played a very important role in bringing down inflation globally through free movement of goods as well as labour. Any reversal of the same could create significant inflationary pressures. Secondly, there could be a serious mismatch between the demand and supply of US treasuries going forward which could raise term premiums further.

In the past few years, the US Treasury has needed to (on net) raise about three percent of U.S. GDP from the market to fund the budget deficit. A portion of the deficit has been funded with short-term debt, so funding deficits of that size have required roughly 2% of GDP per year in (net) issuance of Treasury bonds and notes. However, with the Trump tax plan, the fiscal deficit is rising toward 5.5% of GDP, which implies that the Treasury will need to sell about 4 percent of GDP of bonds (on net) a year—not the roughly 2 percent of GDP it now sells. On the other hand, the Fed will be cutting back its Treasury portfolio at an annualised pace of $90 billion a quarter, or a bit under 2% of GDP, once the roll-off is fully phased in. The market consequently will likely need to absorb over 5 percent of GDP of longer-dated Treasury issuance—a real step up from the current level.

It is very usual that equities perform well when bond yields rise – it is a clear sign of growth. However, two things need to be kept in mind about the current cycle. Firstly, ultra-low interest rates have propelled global equity valuations close to record high levels. Some mean reversion is likely as interest rates rise. Secondly, thanks to ultra-low interest rates, U.S. firms have spent roughly $4 trillion on share buybacks since 2009, making corporations the biggest single source of demand for U.S. shares. Buybacks have “accounted for +40% of the total earnings-per-share growth since 2009, and an astounding +72% of the earnings growth since 2012”! This trend is also likely to be impacted as the cost of debt rises further.   

Coming to India, the Indian bond market has been in the midst of a massive turmoil of its own in the last few months. From a low of 6.4%, the Indian 10-year G-sec has seen a jump of more than 120bps in a span of just 4 months! It is important to note that Indian G-secs have seen a sharp sell-off at a time when yields in other EMs have been extremely contained (Table 1). Thus, it is clear that local rather than global factors have been responsible for the recent carnage in the domestic fixed income market. 

Table 1: Sharp Under-Performance of India 10-Yr G-Sec vs. EM Peers

So what has brought about this movement? As is the global case, inflation does not seem to be the culprit in our case too. While the inflation prints since Nov-18 has inched higher, it still remains comfortably within the RBI mandate. Moreover, both RBI and consensus forecasts for the next 1 year remains relatively benign. Also, what is rather interesting to note the current gap between the repo rate and the 10-year G-sec is unusually large (more than 150bps). In fact, it is the highest ever barring the period of the Great Financial Crisis (Chart 2). On the face of it, this implies that markets are pricing an extremely aggressive RBI hiking cycle (atleast 75bps of rate hikes this year). However, neither RBI's current inflation forecast nor its current stance warrant pricing of such aggressive hikes. In other words, bond markets seem to be perturbed not by RBI but by some other factor.

Chart 2: The Gap between the 10-Year G-Sec and Repo Rate is unusually large

This "other" factor appears to be demand and supply. On the supply side, fiscal slippage in FY18 as well as concerns over the FY19 deficit target (on the back of optimistic GST projections) seems to have made markets rather uncomfortable. On the demand side, as the demonetisation induced surplus liquidity situation has quickly evaporated and as credit growth has picked up (rising credit-deposit ratio), the demand for G-Secs by commercial banks has progressively come down (Chart 3). The demand angle has been further exacerbated by PSU banks not willing to buy G-secs due to complete erosion of their treasury income which were the biggest contributors to their calendar 2017 profits. In fact, volumes in the bond market seem to have collapsed quite a bit. Bond trading volumes averaged Rs.290bn a day in the first two months of this year vs. Rs.435bn in the same period last year. 

Chart 3: Rising CD ratio resulting in reduced demand for G-Secs

As we know, the Indian economy is in the early stages of a cyclical recovery after being impacted by two major disruptions – demonetisation and GST. Given that the recovery is quite nascent, rising cost of capital does not bode well for the sustainability of the economic acceleration. Moreover, cost of capital has risen even before RBI has embarked on its rate hike cycle which suggest that domestic liquidity conditions remain very tight. In such a scenario, it becomes important for the RBI to refrain from further adding to the financial tightness. It is quite likely that liquidity situation improves momentarily in 1QFY19. This could be accompanied by some cyclical pickup in inflation aggravated by base effect. However, RBI should overlook these developments and maintain status quo. Also, when liquidity starts to turn unfavourable in the latter months, the RBI should proactively supply durable liquidity (via OMOs). A delayed response could lead to further hardening of rates. Growth has suffered too much for too long. Protecting the ongoing nascent growth recovery is now the urgent need of the hour for policymakers!