Rising Inflation Make Bonds Unattractive

Fri, 20 May Pre-Open

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The data pertaining to inflation for the month of April suggest that the retail inflation is on the rise. Retail inflation for April came in at 5.39%.  Now, this is way higher as compared to 4.83% in the preceding month.

The rising retail inflation is mainly on account of increasing fuel and food prices. Talking about fuel, the price of the Indian basket for crude oil has gone up by more than 71% between February and mid-May. This in-turn leads to increase in the prices of the food items because of the logistics cost involved.

Further, drought has played its part too. Reservoir levels are down in many parts of the country. This has affected the sowing of crops, leading to lower production and higher prices of food items.

Owing to the rising inflation, it seems likely that Mr Raghuram Rajan will maintain a status quo on the interest rates in its policy review meeting on 7 June 2016. RBI expects inflation to be around 5% by March 2017. Further, a normal rainfall as predicted by the Indian Meteorological Department (IMD) will help keep the inflation numbers in check. However, if the rain gods disappoint, there may even be a case wherein the RBI increases the interest rates.

Connecting Inflation to Bonds!

The rising inflation has dissuaded the foreigners to bid for the government securities. Now you must be wondering how! The explanation to this is simple.

There is a positive correlation between the bond yields and the interest rates.  Thus when RBI chief reduces the repo rate, there is a simultaneous fall in the bond yields.

Whereas, there is an inverse relation between the bond prices and the bond yields. So a situation wherein interest rate reduces, the bond yield too reduces. And when this happens, the bond prices moves in an upward direction.

The situation explained above was what India went through from the beginning of January 2015, wherein RBI started reducing rates. The foreign investors were benefiting from the gains of increasing bond prices.

This situation could possibly reverse now. Rising inflation could potentially lead to RBI keeping a status quo on the interest rates or even increase them. This situation will lead to bond prices moving lower. This will dampen the interest of the foreign investors. In fact, recently India failed to meet its goal at an auction of debt-investment quotas for the first time in three years. This is the first signals of fading enthusiasm of foreign investors in the bond market.

All eyes will now be on the inflation level and RBI monetary policy to assess its impact on the bond market.

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