Why is the lack of volatility worrying?
When any market is held stable by a powerful force, which is RBI for bond markets, the tendency in the market is to build highly leveraged and risky positions in any asset class that benefits from low interest rates and high liquidity. Equities, commodities, credit spreads are beneficiaries of central bank largesse, and all these markets have seen surge in prices or fall in spreads in case of credits. There is talk of market bubbles on high valuations and excessive speculation.
Such rise in asset prices cannot be sustained if economy does not deliver to forecast and something or the other acts up, which is seen in the spike in inflation. While central banks may say that inflation is transitory, they can never be certain, as they always go by data, which is a past indicator and no one can predict the future with certainty, else there will never be market and economic meltdowns.
Market volatility constantly readjusts positions, enabling the market to calibrate leverage and speculation. It is necessary for markets to correct, may be for short term if long term outlook is positive or for long term if there is a bubble burst. This is normal market behaviour and the system emerges stronger after each market correction. Hence when there is lack of volatility in markets, the foundations get weaker and weaker, making the whole system wobbly.
Fed rate hike, CPI inflation hardly move bond yields
The US Federal Reserve signalled rate hikes earlier than expected on rising US inflation. India saw a surge in CPI inflation in May 2020. Normally, bond markets will react to such news by selling bonds, especially if bond yields have been stable for almost one year, with 10-year government bond yield at around 6% levels give or take 20 to 25bps volatility, which is nothing. However, bond yields stayed stable with yield on the 5.85% 2030 bond actually falling on the back of RBI buying the bond at 5.99% in the G-SAP auction held last week.
RBI has been steadfastly keeping a tight lid on yields on the 10-year bond and this has made the markets nervous on any directional play in yields, especially on the short side.
US FOMC maintained interest rates at 0% with indication of two increases by the end of 2023. In addition to it, US Fed kept the target range for its benchmark policy rate unchanged at zero to 0.25% and to continue asset purchases at a USD 120 billion monthly rate until substantial further progress have been seen on employment and inflation. The monetary committee is projecting US economy to grow at 7% for current fiscal year and raised its headline inflation expectation to 3.4% for 2021, a full percentage point higher than the March projection, but the post-meeting statement continued to say that inflation pressures are “transitory.”
India's retail inflation climbed to a six-month high level at 6.30% on yearly basis in May 2021 from 4.23% in previous month. The rise has been driven by higher food, fuel and energy prices. In the same line, Consumer Food Price Index (CFPI) experienced a sharp rise to 5.01% in May 2021 against 1.96% in April 2021. Core inflation also rose to 6.6% in May 2021 from 5.4% in April 2021.
Government bonds, SDL and OIS yield movements
During the week, 5.85% 2030 yield remained unchanged at 6.01% while the 5.77% 2030 yield increased by 6 bps to 6.20%. 5-year benchmark bond, 5.22% 2025 yield rose by 15 bps to 5.26%. 6.57% 2033 yield went by 10 bps to 6.62%. Long-term paper 7.16% 2050 yield gained 6 bps to 6.99%.
The spread of 10-year bond over 5-year bond (5.22% 2025) declined to 60 bps from 75 bps in previous week. The 15-year benchmark over 10-year benchmark spread rose to 61 bps from 51 bps while 30-year benchmark over 10-year benchmark spread increased to 99 bps from 93 bps.
Average 10-year SDL auction cut-off remained stable at 6.80% from 6.81% during previous week. Consequently, spread declined to 76 bps as compared to 80 bps during previous week.
On weekly basis, 1-year OIS yield rose by 14 bps to 3.83% while 5-year OIS yield increased by 22 bps to 5.28%.
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