Vijay Kumar Gaba

The market participants in India must be relaxed after a strong equity market rally in the past 4-5weeks; and stable INR and bond markets. To that extent the RBI has played its part rather well. It has repeatedly reassured the markets about its commitment to the economic growth and stability in the financial markets. Despite turmoil in the global energy and food markets and geopolitical concerns, the RBI managed to contain the volatility in currency and debt market to very moderate levels.

With this background in mind, the market participants are obviously complacent to the likely outcome of the meeting of the Monetary Policy Committee of RBI this week. It seems to be a consensus view that the MPC may use some stronger words to express the concerns about rising prices and exacerbated fiscal pressures, but may stop short of hiking policy rates or changing its accommodative policy stance. Given the fragility of the economic recovery and elevated global uncertainty, the last thing RBI would want to do is to make a disruptive move.

Nonetheless, the participants in the equity markets must be keeping a close watch on the developments in the bond markets. The bond yields have been rising ever since the RBI announced government’s borrowing calendar for 1HFY23. The government is likely to borrow Rs8.45trn form the market in next 6months. This is about 59% of the total budgeted borrowings for FY23. A view is developing that notwithstanding the robust tax collections and consistent alignment of fuel prices to the market prices, the government might need to borrow more than the budgeted due to higher farm and food subsidies. Accordingly, the yield curve in India is very steep in the 1 to 10yr maturity band and mostly flat in the 12-30yrs maturity band. This is in sharp contrast to the inverted yield curve in the US.

As per the conventional wisdom, an inversion in yield curves (2yr yields higher than 10yr yields) usually precedes recession. A steeper yield curve on the other hand reflects expectations of a stronger economic activity and therefore higher inflation in the short term.

The impact of a steeper/inverted yield curve could however be different. As per the conventional wisdom the stock market factors in the future events well in advance. The earnings forecasts and stock prices are adjusted to factor in all known future events. Of course there is subjectivity in the analysts’ assessment and pricing methods used, recognition of the event itself is usually uniform, with very few contrarian views.

It is therefore reasonable to believe that the US equities are already pricing in a recession in next six months and may not see much correction from the current level despite few rate hikes by the Federal Reserve. Whereas, the Indian equities might be pricing in a stronger economy and there could be some scope for disappointment. A rise in benchmark yields to 7.25-7.5% (as presently forecasted by most analysts) could cool the heated equity markets.

However, this view is subject to deftness of RBI in managing the bond market. Higher FII allocation; continued use of innovative tools; and a sharper global commodity price correction could keep the bond yields under check (or even result in lower yields) and fuel the equity prices further.

Whatever be the case, for sometimes the bond market may be the guiding factor for equity markets.