Bond market crashes as RBI hikes borrowing costs for banks

The bond market crashed in early trade on Tuesday with the 10-year government securities (G-Sec) yield surging 50 basis points (bps) to trade at over 8 per cent.

The 7.16 per cent G-Sec 2023 was quoting at 8.06 per cent, up 50 bps compared to Monday's closing of 7.56 per cent. In effect, this mean the 10-year bond lost Rs 3.50 this morning. Against its face value of Rs 100, it is now trading at Rs 94, Rs 6 lower.

The crash in bond prices comes after the Reserve Bank of India (RBI) raised the cost of borrowing (marginal standing facility) for banks by 2 per cent to 10.25 per cent.

"This is the first time since 2008 that the yields have jumped 50 basis points in a single day," says Vikram Dhawan, Director at UK-based Equentis Capital.

This clearly indicates that the RBI's focus is on controlling inflation and stemming the rupee's depreciation rather than encouraging growth. Last week's higher inflation and lower index of industrial production (IIP) numbers had already indicated that the central bank would not cut rates in coming days.

Though the rise may have come as a surprise to some, the RBI, in fact, had limited options to stop the continuing fall in the rupee's value.

The rise in rates have had immediate effect - the rupee surged 64 paise in early trades on Tuesday, reaching Rs 59.25 agains the US dollar, compared to Monday's close of Rs 59.89.

This may have come as a breather, but on month-on-month forward, the rupee premium is trading at over 6 per cent, while one-year forward is at a premium of 4.5 per cent.

Comparing the one-year swap to the one-year forward, the swap is trading at a premium of 7 per cent, a huge differential of 2.5 per cent, indicating continuing pressure on the rupee. Usually the difference between the swap and the forward is around 0.5-1 per cent.

Though today's development may augur well for the rupee, the problems relating to the weak rupee, inflation and the large current account deficit (CAD) still continue to weigh heavily.

When it seemed that the worst was over for the bond market, the continuing depreciation of the rupee following sustained selling by FIIs will see a sword hanging over our markets.

Says Dhawan, "Following the uncertainty in the rupee, no one is interested in buying bonds at these levels, which is why there is huge supply in the market."

Adds Sanjay Nayar, CEO at private equity firm KKR, "The currency fall can be arrested with the rise in (BOND and G-SEC) rates." He meant that at present the rates aren't lucrative for an FII to hold on to BONDS, and therefore he is selling.

Higher bond rates are the only way FIIs will be attracted to buy bonds which can also help in arresting the rupee's fall.

These are going to be short-term measures and if there has to be a structural change, India will have to grow beyond 5 per cent and bring down ITS current account and fiscal deficits. Currently, this looks like a distant dream.