RBI's tolerance for higher yields may mean end of transmission

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The Reserve Bank of India (RBI) is now far more tolerant of higher yields at auctions than it used to be. This may have been spurred by the need to keep the market interested in local bonds and position itself for the impending tightening of rates in the overseas markets.


However, this could also mean that all rates linked to the money market will adjust towards hardening. And, this may well be the end of rate transmission of the policy, say market observers.


After years of experimentation, policy transmission has become highly effective and occurs almost in real time in money markets. The lending rates of banks, though, are far stickier, especially in the case of existing loans. For example, between February 2019 and now, the RBI pared its repo rate by 250 basis points (bps), but the weighted average outstanding loan rate of banks fell only 111 bps. For new rates, the transmission was much better as banks lowered their rates by 216 bps, the RBI’s July bulletin showed.


If the bond rates harden, the transmission on fresh loans will be quicker too. And that is why the central bank is always wary of letting bond ra­t­es, especially the 10-year bo­nd yield, rise as that is the ben­chmark for many other rates.


The first indication of the central bank being accommodative on rates came a fortnight ago, when it allowed the cut-off of the new 10-year bonds at 6.10 per cent against its earlier practice of keeping the yields contained at 6 per cent.


Since then, primary dealers have not been forced to buy unsold bonds, and the central bank accepted cut-offs closer to market yields.


“RBI’s flexibility, and perhaps apprehension of rejection from the market, was apparent when it adopted a uniform method of auction from multiple pricing auctions. This automatically raised the cut-off near the market rate as frivolous bids were eliminated (since in uniform auctions, all bidders get a chance to own the bonds), and all the bidders bid near the market price,” said a senior bond trader, requesting anonymity.


The RBI in the past has tried to keep the 10-year bond yield contained at 6 per cent with all the means at its disposal, including buying most of the existing stock from the market.


But that only distorted the yield curve, as the medium-term rates remained soft even as the short-term and longer-term rates remained elevated. This depression at around the 10-year segment has been corrected now to a large extent, but trades are not as high as it should be owing to the lack of tradable securities in the 10-year segment.


In the absence of the 10-year bonds, the 5-year benchmark bond is the most traded. Interestingly, as the RBI realigned its market rates, yields on the 5-year segment have fallen about 12 bps in a week, which is more than in other sections of the yield curve, indicating normalisation of the yield curve.


At the same time, long-term rates are readjusting to higher levels.


“This is repairing the yield curve, which reflects the true rates of the economy,” said the treasurer. Such normalisation in the yield curve would also be crucial when portfolio money thins at every indication of rate tightening by the US Fed, as the investor would become selective in putting their money in a country where the rates are transparent, the treasurer said.


Rates overall could already be tightening even as the RBI continues to maintain its accommodative stance, economists say. “At the next policy meeting on August 6, we expect the RBI to raise its inflation projection, but reiterate its accommodative stance to support growth. However, we exp­ect inflation to be more persistent than the RBI’s current tra­n­sitory assessment, resulting in a policy pivot towards normalisation later this year,” Nomura said, adding it expects 40 bps hike in reverse repo rate in Q3 and a cumulative 75 bps repo hike in 2022.

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