Between July 2017 and March 2018, the yield on 10-year benchmark bonds in India went up 138 bps from 6.40% to 7.78%. In the last 10 days, the bond yields have fallen 60 basis points from 7.78% to 7.18%. The first trigger for the fall was when the government went out and announced a H1 borrowing target that was almost 23% lower than the previous year. That satiated the market as it meant that government borrowing pressure will not spook bond markets. Secondly, the monetary policy retained its neutral stance on rates and that also pushed down yields…

Why yields needed to fall?

The government needs lower yields as it will mean that banks and debt funds do not suffer MTM losses on their bond holdings. This will build up their appetite for government bonds. A higher appetite for bonds will give the government the leeway to gradually increase its debt targets for the second half of the year.

Problem in rising yields…

The first part of the dilemma for the government is that if bond yields rise then the risk of FPI outflows is largely addressed. But it will result in MTM losses for bond holders. Above all, the liquidity could virtually dry up in the bond markets as was seen a few weeks ago. That would not be too conducive for the government borrowing program.

Problem with falling yields…

While falling yields would be positive for banks and debt funds, it would be hard to sustain falling yields if inflation was to go up. With the new MSP formula in place, food inflation and fuel inflation are likely to go up. With IIP on auto mode, the RBI really does not have a ready case for rate cuts. Above all, falling yields will squeeze the yield differential with US benchmark and that will give an incentive for risk-off. That will be RBI’s dilemma in 2018-19!