By Pankaj Pathak
The Indian bond markets have been mollycoddled over the last three years by the incredible actions of the central bank. The Reserve Bank of India (RBI) cut interest rates, eased liquidity, and bought record amounts of government bonds to anchor market interest rates at low levels.

As growth recovers and inflation rages, the central bank in India and around the world will not only raise interest rates but will also reduce liquidity support to the bond markets. The possible divergence in the timing, the extent and the pace of the actions will be the key driver for the bond markets in 2022. Misunderstandings are likely to creep into this symbiotic relationship. Trust will be at a premium. Divergent viewpoints will lead to volatility.

We expect considerable volatility in the Indian bond market in the coming six to nine months due to:
a) Divergence in the actions of RBI and its expectations in the bond market
b) Divergence in the actions of the US Fed and its expectations in global asset markets
c) Divergence in the exit policies of central bankers around the world impacting asset prices and flows to India.
Divergence on inflation assessment

In India, the consumer price inflation (CPI) averaged 5.96% in the last 24 months (December 2019-November 2021) as against an average of 4.1% in the preceding five years (December 2014-November 2019). Although the last three readings of headline CPI inflation were between 4%-5% (4.35%, 4.48% and 4.91% in September, October and November 2021, respectively), it was largely due to base effect from high CPI reading during the same months of last year (7.27%, 7.61% and 6.93% respectively in Sep, Oct and Nov 2020).

Much of this distortion in inflation numbers was caused by a sharp rise and fall in vegetable prices. The ex-vegetable inflation, which constitutes about 94% of the CPI basket, stood between 6.64%-6.87% during the last three months; and for the last 12 months, it averaged at 6.4%. This is not just significantly higher than the RBI’s inflation target of 4%, it is also holding above the RBI inflation tolerance band of 2%-6%.

India in the world of uncertainty
Monetary tightening (liquidity withdrawals and rate hikes) in the developed world typically causes capital outflows from emerging markets (EM) and puts pressure on EM currencies and bonds. EM countries with low/negative real interest rates (interest rates minus inflation rate), high debt levels and wide fiscal and current account balances are more vulnerable.

Divergent yield curve
Since the start of 2021, bond yields have already risen a lot in expectation of liquidity tightening and eventual rate hikes. Thus, gradual rate increases which are well-communicated will be absorbed comfortably. However, we may continue to see a gradual increase in short term yields as central banks increase rates and reduce liquidity.

Long term bond yields may remain range-bound around current levels or move up only marginally as we expect this rate hiking cycle to be much shallower with RBI trying to keep the terminal repo rate closer to 5.0%-5.5%. Long-term bond yields, though, face risks from a sudden change in stance from central banks. India faces this risk from an increase in oil prices or a rise in food prices. This would force RBI to hike interest rates sharply and markets could face higher volatility.

The writer is fund manager, Fixed Income, Quantum Mutual Fund