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Looking Through the Noise

In the bond market, the sentiment pendulum has swung from one extreme to another over the last two months. Relentless rise in the US treasury yields and surprise jump in domestic inflation have rattled the investor sentiment in the Indian bond markets pushing bond yields higher and prices lower. 

The 10-year Indian government bond (Gsec) yield which had fallen to lows of 6.95% in May, has jumped to the peak of 7.26%, before pulling back to the current levels of 7.22% on August 21, 2023 

Chart – I: Indian yields tracking UST, Crude and Inflation on way up

Past performance may or may not sustained in the future.

The underlying forces driving the bond yields over the last two months, continue to remain uncomforting -

• The US 10-year treasury yield, after rising sharply from levels of 3.5% during May 2023, is now holding above 4.2%.
• The Crude oil price has risen more than 16% over the last two months and is still holding above the USD 85/barrel.
• The headline consumer price inflation in India jumped to 15 months high of 7.44% in July 2023 and expected to remain elevated for the next few months.

Chart – II: US treasury yields moving higher on resilient growth data and heavy supply

Tipping Point

The recent significant jump in the US treasury yields seems justified given – (1) the resilience shown by the US economy and the labour markets, and (2) sharp jump in treasury issuances.

However, for long term yields to go even higher and sustain there would require incremental strengthening of economic activity and serious worsening of future inflation trajectory. These conditions seem unlikely to hold given the synchronised global monetary policy tightening will continue to put restraint on demand.

We also note that interest rates in most of the developed world are at a level not seen in long time. The financial system in many places including the US is not accustomed to this high interest rates. This makes the financial system vulnerable to shock if the current level of US treasury rates sustains for long or move higher.

We have seen some short episodes of financial system vulnerabilities during September 2022 in the UK pension funds and during Mar 2023 in the US regional bank crisis. Once again, the financial condition in the US is tightening quickly. This is at a time when the corporate default rate is also showing an uptick.

In our opinion, the financial system risks should outweigh the supply risk in the US treasuries. We see higher probability of long-term US treasury yields coming down than moving higher.    

Inflation havoc

In India, the inflation momentum was falling since start of the year until May, when vegetable prices started to rise sharply. The CPI inflation spiked to 15 months high in July to 7.44% as against average inflation of 4.65% between April- June 2023.

However, the pickup in inflation was not broad-based. It was almost entirely contributed by the sharp surge in food prices especially that of cereals (11.02% yoy), Milk (8.02%), vegetables (33.96%), pulses (12.08%) and spices (20.09%).

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