The significant rise in 10-year US Treasury yields have caught markets in general off-guard. While yields did retreat from 15-year high of 4.34% to ~4.12%, these are quite high compared to 1.7-2% levels seen in early 2022. What are the factors that led to the rise in yields and should higher yields be a concern for India?
The upsurge in yields has been a culmination of few factors - consistent interest rates hikes (11 times since March 2022) by the US Federal Reserve (Fed) to curb inflation, a high fiscal deficit and increased debt issuance from $733 million to $1 trillion in the July-September period. The changing narrative of the US economy – from pricing in a recession to a soft landing to incoming data showing a relatively resilient economy – the markets have seen and priced it all. Expectations of a slowdown have now been pushed towards the next year given the strong macroeconomic picture and markets now expect interest rates to remain elevated.
The sell-off in US Treasuries spread to many countries globally, including the UK and Europe. In India, the spreads between the 10-year Indian government bonds and the US Treasuries narrowed to less than 290-300 basis points, given that the Reserve Bank of India (RBI) has maintained a pause since April 2023 as against the Fed’s hikes.
Source: Bloomberg. The above graph is used to explain the concept and is for illustration purpose only and should not used for development or implementation of an investment strategy. Past performance may or may not be sustained in future.
It is pertinent to note that the US has faced unprecedented inflation since 2022; these levels have not been seen in the last 40 years and the average American has seen flat to low inflation and near zero interest rates thereof in the last decade. India on the other hand, as an emerging economy has been witness to periods of high inflation and high interest rates. For 16 consecutive months between September 2021 to December 2022, US inflation has been ahead of India which has not been the case in the last decade. India’s interest rate trajectory has seen a measured rise when compared to that of the US and the same goes for inflation too.
Contrary to the belief that a narrowing differential may not be good for the rupee, the currency has stayed in a narrow range through 2023. Furthermore, FPI inflows into Indian markets since April have been quite strong allaying fears that FPIs could withdraw if the differential narrows due to rates hikes by the Fed. The inflows have largely been on account of the robust macroeconomic scenario in India and its potential in the face of slowing growth globally.
Given that Indian bonds are largely domestic owned, one shouldn’t expect any sell-off in response to US nor should one expect a dramatic depreciation in the rupee. India’s external sector is in a much better situation today - a lower current account deficit and improving foreign exchange reserves - these bode well for India. Furthermore, the Fed is almost at the top of its tightening cycle. We expect limited upside risk to yields for now but will be watchful of the price pressures and oil prices. Domestic factors than external could play a pivotal role in determining the direction of bond yields.
In the current scenario, investors may use this rise in yields to increase duration and stick to short to medium term funds with tactical allocation to long / dynamic bond funds. One can expect yields to be lower by 25-40 bps in next 6-12 months across the curve. Investors could look at actively managed strategies to capitalize from fluctuations in rate movements. While the overall strategy is to play flat/falling interest rate cycle over the next 18-24 months, markets are likely to see sporadic rate movements. In such a scenario, active funds are ideally positioned to toggle across duration and the ratings curve to optimize medium term returns.
Source of Data: RBI Governor’ Statement, RBI Monetary Policy Statement & RBI post policy press conference dated 10th August 2023, Axis MF Research
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