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Why Indian Bond Yields Are Falling Sharply?


Posted on 19-Jul-2019 Comments  0

Bond Yields

Why are Indian bond yields falling so sharply in July

During the third week of July, the 10 year benchmark bond yields touched a 20-month low of 6.25%. The last time these levels of yields were seen was in the last quarter of 2017; and that is a long time back. What is surprising is that this fall has been really rapid after it breached the 7% mark. In fact, a recent report by Deutsche Bank has pegged Indian benchmark yields as closer to 5.5% by next year. What does this really mean for investors?

Decoding bond yields

Bond yields have been largely a function of the rate direction set by the RBI as well as the liquidity in the system. Bond yields do tend to taper when there is substantial liquidity in the system as we got to saw during the aftermath of the demonetization in November 2016. But bond yields in India have followed a curious path in the last one year. Back in mid-2018, bond yields started rallying after the US hinted at more aggressive rate hikes due to rapid growth and rising inflation. Even as the US bond yields crossed the 3% mark, Indian bond yields crossed the 7.5% mark and eventually peaked at around 8.3% in October 2018. This not only marked the peak of the liquidity crisis in India but also a reaction to a sharply lower rupee which had gone as low as 75/$. In the middle of all this, two consecutive rate hikes by the RBI only worsened matters for bond yields in India. Since October, yields have been steadily down.
Rate cut expectations

There are 2 levels of rate expectations for the bond markets. While the first one pertains to expectations from the US Fed, the second pertains to RBI expectations. The CME FEDWATCH indicates a 100% probability of a rate cut when the Fed meets on July 31st. But what is more surprising is that there is almost a 50% probability that the Fed would cut the Fed rates by 50 bps from the current level of 2.25-2.50% to a level of 1.75-2.00%. That would be the kind of rate cut that would have been almost inconceivable even 3 months ago. If the Fed obliges with a 50 bps cut, it is being estimated that the RBI may follow suit with a 50 bps rate cut. This would result in a net reduction of 75 basis points in rates since June 2018 and would be really meaningful for pushing growth higher. 

But, growth is the real worry

We cannot miss the irony of the situation here. Normally, it is the rates that lead the yields. What we are currently seeing in the Indian economy and the global economy is the falling yields leading monetary policy. And that is not a very good sign. When yields fall ahead of monetary policy, it is a case of low growth expectations dragging the rates lower. That is phenomenon we are seeing globally. That is not an occasion to celebrate falling rates. It is actually a time to be cautious! 

Iran Face-off

Iran could pose a significant risk to global commodity markets

The Persian Gulf and the Strait of Hormuz is becoming the next big flash point in the Middle East situation. The problems started with the US imposing sanctions on Iran for not adhering to its side of the nuclear agreement. The sanctions were intended to break the economic backbone of Iran by cutting off their oil export routes. But this could pose a big risk for commodities.

The recent flashpoints

The problems in the Persian peninsula started a couple of weeks back when the UK seized an Iranian tanker off the coast of Gibraltar as it was apparently carrying oil to Syria. Since Iran was under sanctions, the tankers were seized. Iran retaliated by threatening British tankers near the Strait of Hormuz before backing off after warnings from British warships. The situation had apparently taken a turn for the worse in the last week when the US began by shooting down an Iranian drone. In the meanwhile, Iran has also seized two tankers under a British captain and held the crew captive. The Strait of Hormuz continues to be critical to the movement of oil and gas from the Middle East to the rest of Asia and Iran is surely trying to drive a hard bargain on this front. As of now both the US and Iran have avoided a full-fledged conflict. But the recent seizure of tankers by Iran has already been declared as an act of war by the US. But the bigger question is what this could mean for commodities?

Will the Strait be shut?

In the event of a declaration of war, it would largely depend on whether it is a limited confrontation or a full-fledged war. In a limited confrontation, the normal flow of traffic through the Strait of Hormuz is likely to continue. Of course, this would include a caveat that some of the flags might be in danger when they passed through the Strait. However, in the event of a full-fledged war, the Strait of Hormuz could be shut and Iran could also lay land mines which would make it hard for ships to pass by. That would be a worst case scenario.

Why India must worry

While most experts rule out a full-fledged war, even limited confrontation could be expensive. For example oil could rise to $90/bbl and this would be driven by futures buying before falling demand starts to impact oil prices. Also, the flow and price of LNG could be hit harder by the conflict as the Strait remains central to LNG transportation. Apart from Japan and South Korea, India also has a major reason to be worried. India currently imports nearly 85% of its daily oil needs and 70% of these imports come from the Middle East. Even a limited conflict could be extremely inflationary for India and also worsen its current account deficit. After all, 10% rise in oil prices widens CAD by 0.40% of GDP. For the Indian economy, that could be bad enough!

IL&FS Auditors

Why the government is justified in asking for a 5-year ban

If the Indian government has its way, then Deloitte Haskins Sells (DHS) and BSR could be the first instances of auditors getting a 5-year ban. The government has already moved a petition in the NCLT, which has since been challenged by DHS and BSR. While the auditors have raised technical objections, the government has a strong case and must prevail to protect the integrity of Indian markets!

Auditor objections

While both the auditors have challenged the government petition on a number of technical grounds, there is no denying the poor quality of audit done by the two auditors. For example, DHS had contended that it had ceased to be an auditor when the proceedings seeking a ban were initiated and the remedy was only available against existing auditors. DHS also contended that since the rules only pertain to existing auditors, they would be out of the definition. BSR, the other auditor, has also raised a similar objection saying that they had ceased to be auditors when the said proceedings had been initiated. The auditor’s counsel has also contended that Section 140 does not allow the NCLT to change the basic definition and interpretation of Section 140, under which the state has filed the petition. That power is only available to the High Court and the Supreme Court of India. Hence both auditors have sought to quash the ban on purely technical grounds.

The MCA contention

The MCA which filed the petition has its own justifications. The MCA counsel has contended that considering the systemic risk posed by IL&FS the focus should be more on protecting the integrity of the financial system. Also, the SFIO had noted the lapses back in November 2018 and hence the concept of deemed removal was not valid. Also, in past cases, the Supreme Court had allowed the expansion of the above definition to allow remedial measures against auditors. The MCA has also drawn on the concept of natural justice to justify why the auditors should be banned.

Why MCA has a valid point

For a long time, the audit professionals have tried to take umbrage behind their sole accountability to the ICAI, which is a statutory body in itself. That has been largely diluted with recent orders passed by SEBI. But the point is much deeper. It is high time the auditors (and also the rating agencies) are held accountable for such cases, which appear to be a case of lapse and connivance. Auditors should not be allowed to hide behind the veil of technicalities. The bottom line is that had the auditors applied better due diligence the IL&FS fiasco could have been prevented. That is where the auditors have failed as a watchdog. The MCA must make the punishment in this case exemplary, considering the larger systemic losses caused by IL&FS!

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