RBI is maintaining an ultra accommodative monetary policy to negate the effects of covid 19 pandemic that has led to 2 consecutive quarters of negative GDP growth in fiscal 2020-21. While growth collapsed, inflation has risen sharply to well over 7% levels, far above the RBI target of 4%. Forecast for inflation is around 5% in the 1st half of fiscal 2021-22 while growth will rebound considerably, largely on base effect. RBI is willing to live with real interest rates of negative 4% for growth to accelerate.
The government is providing support to the economy by spending heavily on the farm sector and providing sops to the private sector in the form of lower taxes that were cut sharply last year. Revenues in the meanwhile have declined sharply due to lockdown and the fiscal deficit is ballooning and is currently at 126% of budget as of October 2020. States too are struggling with deep holes in budgets and are forced to borrow to spend.
Given that the government spending is required to boost growth, RBI is keeping a lid on bond yields rising through OMOs. Bond yields have largely stabilized with 10 year bond at levels of 5.8% to 6% after spiking a few months ago to levels of 6.2% as markets feared policy tightening on high inflation.
Fiscal deficit could well be around 6.5% to 7% of GDP this year and next against budgeted levels of 3.5% and below. Such levels of fiscal deficit cannot be maintained, as it would lead to crowding out effect on private sector investments. However to bring down fiscal deficit, inflation has to trend higher and nominal GDP growth should be in high double digits. In the financial crisis period of 2008-09, fiscal deficit doubled and nominal GDP growth was running at well over 10% levels for a few years, leading to fall in deficit and for nominal GDP growth to be higher, inflation has to be high at levels of over 7%.
If long term inflation expectations rise to over 7% from 4% levels targeted by RBI, bond yields cannot stay down and keeping a lid on yields will not be an option for the central bank.
Government bonds, SDL and OIS yield movements.
During the week, 5.85% 2030 yield closed at 5.82%, 5.77% 2030 yield came down by 1 bps to 5.90%, while 5.79% 2030 bond yield remained unchanged at 5.93%. 6.45% 2029 bond yield declined by 2 bps to 5.94%. 5-year benchmark bond, 5.22% 2025, yield decreased by 5 bps to 5.03%. In the same line, long term paper 7.16% 2050 yield declined by 2 bps to 6.57%.
The spread of 10-year bond over 5-year bond (5.22% 2025) increased to 90 bps from 85 bps previous week. The 15-year benchmark over 10-year benchmark spread rose to 30 bps from 27 bps. 30-year benchmark over 10-year benchmark spread declined to 65 bps from 67 bps.
In the SDL auction conducted last week, average 10-year SDL yield rose to 6.60% from 6.55% last week. Consequently, spread with G-sec benchmark rose to 66 bps from 64 bps.
On weekly basis, 1-year OIS yield rose by 6 bps to 3.69% while 5-year OIS yield increased by 4 bps to 4.48%.
