Bond market’s grim message

There is a belief in the hedge fund business, of which I was once a part, that the bond market leads events and the stock market follows them. Professional investors pay close attention to what the bond market is doing. What is the bond market telling us about the Indian economy?

But first some basics. The government covers its budget deficit by borrowing money in the capital markets. It issues bonds, and the interest rate it has to pay is determined by the yield on the 10-year government bond. Currently, interest payment on government debt is the largest expense item in the country’s budget. In the 2018 Budget, interest payments were about Rs 5.78 lakh crore and made up 18 per cent of the total expenses. This was twice what the country spends on defence, five times its expenditure on education, and ten times of what it spends on healthcare.

The yield on the 10-year bond is, therefore, critical because higher yields mean more in interest payments and correspondingly fewer funds available for defence, infrastructure, education, health R&D, drinking water, etc.

In May 2014, when the Modi government took control of India’s governance, the yield on the 10-year government bond was 8.72 per cent. This bottomed out to 6.35 per cent in November 2016. In roughly two and a half years, the cost of borrowing for the government dropped by 2.35 per cent percentage points (235 basis point). In addition, the government was borrowing less. India’s budget deficit which was 7.8 per cent of GDP in 2009 was down to 3.5 per cent of GDP in 2016. Both the UPA and the NDA governments deserve credit for showing fiscal restraint and bringing the deficit down over the last eight years.

The combination of lower interest rates and less borrowing meant a saving of almost Rs. 1 lakh crore in interest payments – money that was available for the government to spend on other things. The bond market had given the Modi government a present in the form of more money to spend on infrastructure, education and other priorities.

Unfortunately, things started to turn around in November 2016 after demonetisation. Yields on the 10-year government bond began to climb and have now reached 7.8 per cent. Additionally, the government is now spending more than it estimated and the fiscal deficit is expected to jump to 3.75 per cent of GDP. The combination of loan waivers for farmers and the indexing of the minimum support price (MSP) to 50 per cent of the cost will require a significant increase in government borrowing, all now at a higher rate.

Indian banks have historically been the biggest buyers of government bonds because their reserve Statutory Liquidity Ratio (SLR) requirement of 19.5 per cent is invested primarily in such bonds. As a result, the Reserve Bank of India has been able to control the borrowing costs for the government by managing the rates at bond auctions. But Indian banks are currently in poor shape and with the non-performing asset problem likely getting worse, their balance sheets are stressed. State Bank of India, the country’s largest bank, reported its first loss in nearly 19 years. Many banks already hold up to 30 per cent of their portfolio in government bonds and have taken substantial losses on their bond holdings as the yields have steadily climbed (bond prices go down when yields go up).

The last three RBI auctions of government bonds have been cancelled for lack of interest, and the central bank will now be forced into paying a higher cost for the government’s borrowing.

The government thus faces the prospects of significantly higher interest payments in the coming years. This will have a significant negative impact on budgetary allocations for infrastructure, education, healthcare, and R&D investment in future technologies.

So what is the bond market telling us? Several things. Firstly, it is indicating higher inflation in the future. Yields have a built-in inflation premium and when inflation expectations rise yields increase to compensate for that eventuality. The bond market is telling us that the combination of higher oil prices, a commodity that India is a large importer of, a depreciating rupee which makes imports more expensive, and the expected increase in agriculture MSPs will cause domestic inflation to rise.

Secondly, the bond market has given a thumbs down to the recent Budget and the government’s failure to offer major structural reforms like greater deregulation, smaller government, greater privatisation of production resources, and tax reforms. The budget had no growth-enhancing ideas and was full of expensive subsidies. The bond market understands there is no free lunch and that someone has to pay for all those goodies the government handed out in the budget. Yields on the 10-year bond rose to a 22-month high the day after the Budget.

Thirdly, the bond market is sending a message to the stock market. Inverting the current bond yield of 7.8 per cent gives 12.8 (the math is 1 divided by .078), which implies that investors get Re 1 in earnings from bonds by spending Rs 12.8. In comparison, the price-to-earnings multiple (PE) for the Nifty is 26.5, which means an investor has to spend Rs 26.50 to get Rs 1 in earnings from stocks. The bond market is telling us that stocks are overpriced.

Bond yields are a useful predictor of economic events and stock markets. The recent increase in bond yields raises red flags for both.

The author is the founder, contractwithindia.com. Views expressed are personal.