2026-11-09 11:58:11 am | Source: SBI Capital Markets
Study on Bond Yields Nov'26: r* in US vs. India - Unnatural Rise And Real Consequences by SBI Capital Markets
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Elevated bond yields in advanced economies signal the end of the post-GFC era
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US bond yields had been on a secular multi-decadal decline, and developed country yields entered a race to the bottom in the aftermath of the GFC. Major factors driving this included a savings glut fuelling global demand for Treasuries, structurally lower inflation, and risk-off events such as the GFC, and COVID-19. The same continued till the pandemic, post which there has been a sharp rise in bond yields, with US Treasuries near 2-decade highs, effectively closing the GFC era. In this report we seek to answer if this rise is durable, whether it points to structural changes in the natural rate (r*), and what this means for India?
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Inflation driven rate increments explain most of the rise in yields
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The major driver of the rising yields are inflation driven rate hikes. Inflation, which spiked due to physical restrictions in the pandemic period crystallised in the post-pandemic period owing to geopolitical, protectionist, and strategic machinations. It is widely acknowledged that prices will be higher going forward than seen hitherto, with a new baseline being set. Inflation expectations which are levels not seen since the early 1980s bear testament. Our analysis shows that 75-85% of the rise in nominal Treasury yields in the US may be attributed to inflation since mid-CY20.
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The other 20%: decoding the real role of natural rates using HLW analysis
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The nominal rate (which may be understood as the observed G-sec yield) may be split into the real rate and inflation. Deeming real rate as close to the r* in the steady state, we may further decompose the latter using the HLW model. The same attributes the key driver of r* as trend growth (g), with other slow-moving residuals also in the mix. Notably, in the US context, the relationship between r* and g weakened post-GFC, with convenience yield (cy) emerging as an explanatory factor. Cy represents the premium paid by investors for the safety and liquidity offered by Treasuries over similar corporate bonds. Spiking cy depressed r* well below g right upto the pandemic. However, a reversal is underway as we speak
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A collusion of factors point the r* towards the North Star in the US
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The r* is drifting upwards in the US in recent times. The proximate cause of the same is the high supply of Treasuries given record fiscal deficits, reducing creditworthiness of the US, and overseas investors diversifying to non-USD assets. These trends are expected to persist in the future. Alongside expanding potential growth due to the AI boom and higher cost of capital, this exerts upward pressure on the r* in the USA. Other developed economies such as Europe and Japan, are also expected to broadly follow the trend, subject to local dynamics.
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Drivers of Indian r* appear more stable and CPI is an overwhelming driver
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In the Indian context, stable and fair growth, and anchored inflation expectations in the FIT regime, form the base of stability in r*. Gradual fiscal consolidation and improving credit rating, backed by higher life expectancy and recovery of savings rate from a recent trough are expected to be counterbalanced by continued high GCF and global spillover of rising r* in advanced economies. Thus, Indian r*, while subject to quarterly variations due to timing differences between the moving parts, need not necessarily rise like the US.
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A new differential regime may necessitate a different way of looking at the external front
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Over the past decade or so, we have seen a consistent reduction in the inflation differential between US and India, with no major change in growth differential. This means the policy rate and G-sec yield spread between the two economies has shrunk. This differential is likely to remain at slim levels further motivated by larger gap in r* projected. Ergo, the high dependence on capital account surplus to balance large current account deficit, which was in vogue during the first decade of the 2000s may not longer be feasible. Infact, there has been a steady decline in the sustainable CAD for the Indian economy.
In such a situation, following strategies would be needed to keep the balance of payments in good shape:
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