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Why India’s Rates are Falling but Yields are Rising?
Context: The yield on India’s 10-year benchmark government bond has surged, climbing over 20 basis points since the last RBI rate cut in June. This divergence from the expected pattern points to deeper concerns in the market beyond just monetary policy.
What is the relationship between central bank interest rates and government bond yields in general economic theory?
In general economic theory, there is a strong and direct relationship between a central bank’s policy interest rates (like the repo rate) and government bond yields. This relationship operates through the following mechanisms:
- Direct Correlation with Interest Rates: Central bank rate cuts signal cheaper borrowing costs in the economy.
- When the RBI cuts the repo rate, it typically leads to a fall across the spectrum of interest rates, including those for government bonds.
- New bonds are issued with lower coupon rates, making existing bonds with higher coupons more attractive.
- This increased demand for existing bonds drives their prices up, and since bond yields move inversely to their prices, the yields fall.
- Inverse Relationship with Inflation: Low inflation preserves the purchasing power of the fixed interest payments (coupons) that a bond provides.
- When inflation is low, the real return on bonds is higher, making them more attractive to investors. This increased demand pushes bond prices up and yields down.
- Expectations Theory: The bond market is forward-looking. If investors expect the central bank to cut rates in the future, they will buy bonds today to lock in higher yields, which again pushes current yields down. Conversely, expectations of future rate hikes or higher inflation cause selling, pushing current yields up.
What factors are defying the relationship?
The current surge in Indian bond yields, despite rate cuts and low inflation, is due to a combination of domestic fiscal concerns and global uncertainties that are overriding the traditional monetary policy signals.
- RBI’s Shift to Neutral Stance: In its June policy meeting, while cutting rates by 50 basis points, the RBI also changed its policy stance from “accommodative” (hinting at future cuts) to “neutral” (signaling a pause). The market perceived this as the end of the rate-cutting cycle, removing a key reason to buy bonds in anticipation of future gains.
- Fiscal Deficit Concerns: This is a primary worry. There are mounting fears of a fiscal slippage—the government missing its deficit target. Weak direct and indirect tax collections, coupled with recent cuts in GST rates (estimated to cause a revenue loss of ~₹48,000 crore), have led investors to fear that the government will need to borrow more than planned from the market to meet its spending needs. Higher supply of bonds without a commensurate increase in demand leads to falling bond prices and rising yields.
- Global Factors and Export Worries: The escalating US-China trade war and punitive US tariffs threaten Indian exports. Sectors like gems & jewellery, textiles, and IT services (due to a proposed US outsourcing tax) face uncertainty. Lower exports hurt corporate profits and economic growth, potentially worsening the government’s tax revenue problem and creating a negative feedback loop.
- Supply and Demand Dynamics: State governments have front-loaded their borrowing, increasing the supply of bonds in the market. Meanwhile, weak deposit growth in banks has led to subdued demand from these key institutional investors for government securities, creating an imbalance that pushes yields higher.
What are the implications on the larger economy?
Rising government bond yields have significant spillover effects on the broader economy, often counteracting the RBI’s efforts to stimulate growth.
- Higher Borrowing Costs for Everyone: The 10-year government bond yield is the benchmark pricing reference for all long-term borrowing in the economy. If the government has to pay more to borrow, it sets a higher cost for everyone else. This means:
- Corporate Borrowing: Companies will face higher interest rates on loans and bonds for investment projects, potentially delaying capital expenditure (capex) and expansion plans.
- Retail Borrowing: Home loans, car loans, and personal loans become more expensive for individuals, dampening consumer demand.
- Undermining Monetary Policy: The RBI’s rate cuts are intended to make credit cheaper and boost economic activity. Rising bond yields effectively transmit higher interest rates through the economy, nullifying the stimulative effect of the RBI’s actions and making the monetary policy transmission ineffective.
- Increased Government Interest Burden: A higher yield on new government borrowings increases the interest burden on the national debt. This leaves less fiscal space for the government to spend on crucial areas like infrastructure, health, and education, potentially forcing even more borrowing or cuts in productive expenditure.
- Investor Sentiment and Currency Volatility: Sustained high yields can signal a lack of market confidence in the government’s fiscal management. This can make foreign investors nervous, leading to outflows from debt and equity markets, which can put downward pressure on the Indian rupee.
