RBI Monetary Policy: Bond Markets Await Central Bank's 'Line In The Sand', Says BofA's Jayesh Mehta

A rise in global bond yields.

Higher oil prices.

Nearly Rs 15 lakh crore in central government borrowings.

No sign of a global bond listing.

A central bank trying to normalise pandemic-era accommodative policies.

All that could go wrong has gone wrong for the Indian bond markets. Yields on the benchmark 10-year bond have, in turn, gone from a low of 5.62% at the start of 2021 to nearly 6.90% now. Since the start of 2022 alone, yields have risen by nearly 50 basis points to 6.88%.

They may head still higher, unless the central bank intervenes to draw 'a line in the sand', said Jayesh Mehta, India country treasurer for Bank of America, in an interview with BloombergQuint.

A 7% yield on the benchmark bond seems in sight already but where do we go from here? Are yields headed to 7.25% or 7.50%? "I don't know. Wherever the RBI decides to draw the line," said Mehta.

The pressure will start to build when government borrowings for the next financial year begin in April. Every week, you will see some Rs 40,000-45,000 crore in borrowings, said Mehta.

Sources of demand, meanwhile, remain unchanged. Banks, insurance companies and provident funds remain the large buyers. Typically, a fourth buyer—either foreign portfolios or the central bank—is needed to support the supply of government borrowings.

This year, however, FPIs have been cold to Indian bonds. After withdrawing Rs 10,359 crore in 2021, they have invested Rs 4,184 crore so far this year. Large inflows, without the support of a global bond index listing, are unlikely, Mehta said.

That leaves the RBI, which has been slowly trying to normalise large surplus liquidity conditions. "They are not in an enviable position," said Mehta, adding that the fourth buyer has to be the RBI, otherwise there will be trouble in absorbing the supply.

"Last two years, the RBI has bought so much (in government bonds) and they have to gradually bring that liquidity back to normal," said Mehta.

Some room to buy government bonds may emerge if the RBI has to intervene to support the currency, if foreign outflows pick up due to the U.S. Federal Reserve raising rates. If the RBI sells dollars to stem any fall in the Indian currency, it will suck out rupee liquidity. This, in turn, could give it some room to buy bonds while not adding to the liquidity surplus.

"This, however, is based on a number of 'ifs'," Mehta said.

Could normalisation of monetary policy from the RBI add to the pressure on bond markets? Mehta thinks some of the expected moves from the RBI are already built into yields at current levels.

The Monetary Policy Committee, which meets this week, could look to raise the reverse repo rate from the lows of 3.35%. This would help normalise the interest rate corridor between the reverse repo rate of 3.35% and the repo rate of 4%.

This, according to Mehta, will not adversely impact the bond market, which has been anticipating such a move. The overnight indexed swap market has also built in two to three hikes in the repo rate. A clearer roadmap of normalisation from the RBI may help at this stage, said Mehta.

"They can give some verbal comfort, although that verbal comfort will be worth 5 basis points (on the benchmark bond yield), but yes, the path of regularisation, the path on repo rates (would be helpful)," said Mehta.

"Ultimately, whatever you say, the pain will start when the April supply (of government bonds) starts ... That's where the challenge is. They are not in a position to give a open market operation bond purchase calendar or anything ... but ultimately, you need the central bank when the supply is this extreme," he said.

Watch the full conversation below: