Three Longs & Three Shorts

RBI Bulletin: State of the economy

More than actions, they say, a central bank’s communication has a greater impact on the markets. And every now and then, central bankers resort to rather entertaining language to drive home the point. In its article ‘State of the economy’ featured in its most recent bulletin published earlier this week, India’s central bank, the Reserve Bank of India (RBI) has a go at bond vigilantes. The article starts of with the summary:
“As countries rush to inoculate their populations, the global economy should regain lost momentum in Q2. Bond vigilantes could, however, undermine the recovery, unsettle financial markets and trigger capital outflows from emerging markets. The Reserve Bank is striving to ensure an orderly evolution of the yield curve, but it takes two to tango and forestall a tandav. There is a restless urgency in the air in India to resume high growth, with signs that the capex cycle is uncoiling and turning, and earnings results of corporates having beaten market expectations. Inflation has witnessed upside pressures”
The article gives a comprehensive take on the RBI’s view of the economy but the section on bond markets is topical. The recent sell-off in bond markets globally as well as in India has triggered references to the almost forgotten term ‘bond vigilantes’, a term used to refer to bond market participants who punish fiscally irresponsible governments by selling out of bonds resulting in a rise in yields and hence the government’s borrowing costs. The economist Edward Yardeni is supposed to have coined the term often used in the 80s and 90s only to be forgotten in the era of ever low interest rates and easy liquidity facilitated by central banks across the world.
However, with prospects of inflation coming back in the developed world and closer home, the Indian government’s bold fiscal stimulus have triggered a sell-off in the bond markets. As the RBI suggests in this article, the actions of the bond markets can indeed impede what looks like a promising economic recovery and hence reason for worry.
“…calm returned after the flash bond sell-offs globally and in India that heralded the arrival of March, prompting a calling out of vigilantes who have returned to prowl markets, guns holstered and saddled up…. In India, the benchmark 10-year yield, which had averaged 5.93 per cent during April 2020 to January 2021 surged to 6.13 per cent on February 2 on the announcement of the market borrowing programme of the central government, reportedly higher than what was expected. Following the announcement of a slew of measures by the Reserve Bank on February 5, however, the benchmark eased to 5.96 per cent by February 11. Thereafter, global spillovers in the form of hardening crude prices, announcements of fiscal stimulus, inflation fright as revealed in break-evens and fears of central bank stance reversals, and a lukewarm response to the US Treasury’s primary auction sparked a worldwide stampede in bond markets. With the US 10-year benchmark soaring to 1.6 per cent from around 1 per cent, bond markets in India were pit-roasted by persistent selling and shorting; by March 5, the benchmark in India had touched 6.23 per cent, but the Reserve Bank’s announcements of large-sized operation twists soothed frayed nerves and settled the benchmark at around 6.21 per cent on March 9. Yields, however, firmed up subsequently on spillovers from the spike in US yields.
Although the turmoil was short-lived, it gave a glimpse of the destabilising impact of expectations running too far ahead of outcomes as if with the onset of spring, summer cannot be far behind – as if the recovery has gained full traction and inflation is round the corner. It is a familiar script. The pandemic stirs a heady cocktail – fiscal stimulus; monetary accommodation; release of pent-up demand; vaccine rollout – on which the bond vigilantes thrive. As growth forecasts for 2021 are ratcheted up, they see in them the spectre of long dormant inflation, the archenemy of bonds as it erodes the real value of the fixed income they provide. With these latent anxieties, bond vigilantes turn sceptical about the central bank’s promise to remain accommodative and start the rout. The pretext can be country-specific idiosyncratic factors – more than anticipated government borrowing in India although it is less than last year, both gross and net; the return of break-even inflation on the far horizon in the United States (US), but as the Federal Reserve Chairman pointed out, inflation dynamics can change over time but not over a dime. Moreover, the Fed has said that it will target average inflation of 2 per cent going forward, thereby tolerating inflation above 2 per cent for periods of time. Almost as suddenly, the worst fears about inflation have receded again. There are probably limits to how far an inflation scare can run this early in the economic recovery! Nevertheless, forewarned is forearmed: bond vigilantes are riding again, ostensibly trying to enforce law and order on lawless governments and central banks but this time around, they could undermine the economic recovery and unsettle buoyant financial markets. Fears over US interest rates have already started spilling over on to emerging market economies (EMEs). Investors have started pulling out money from EME stocks and bonds in an abrupt ending of a streak of inflows that had remained uninterrupted since October 2020. The Institute of International Finance (IIF) points out that foreign investment turned negative in emerging market equities and debt from the latter part of February, bringing back fears of the 2013 taper tantrum. While the external balances and debt profiles of many emerging economies are in better shape today than in 2013, they are not immune.”