The Rate Cut in Perspective

RBI surprised everyone by announcing a 0.25% reduction in repo rate (from 8%) yesterday.  The market welcomed this news with a sharp rise. Several self-proclaimed long-term investors welcomed their  prospective notional gains as enthusiastically as they despaired at their notional losses when the markets 'crashed' a few days ago

Here is a perspective of 'where we stand' by a student of the bond market.

Let us start with the definition of bond yield. We will limit ourselves with the simplest definition that the yield represents the IRR of the bond investment, taking into account all the interest payments along with the investment and receipt of the investment upon maturity. Things become complicated if the bond is purchased mid-way but the notion that the yield represents IRR is always true.

When rates fall, new bonds have lower coupon rates (interest rates), resulting in lower IRR and lower yields.  To ensure existing bonds can be sold, their yields must be matched (lowered in this case) to the new bonds. This is done by increasing the price of existing bonds. Thus, higher the price of an existing bond, lower its yield.

The difference between the long-term and short-term bond yields can be thought of as an indicator of the state of the economy and therefore of the equity markets. This idea can be graphically represented by the so-called yield curve, where the current yields of short and long-term bonds are plotted.  I will soon write a detailed post on the yield curve along with a yield curve generator. For now, I will focus on the difference between the 10Y bond yield and the 1Y bond yield.

When the economy is flourishing or if the outlook for the future is positive, money is borrowed for the long-term.  Demand of long-term bonds is high enough, supply is high enough and therefore the  price is low (enough!) and hence during such times, long-term bond yields are higher than short-term yields by about 1-2% or even more.

When no one borrows money for the long-term  fearing a bearish market, the difference between the long-term and short-term yield diminishes (the yield curve is flat).

This phase, where the yields are typically the same irrespective of duration indicates economic slowdown. I don't have access to bond data beyond Sep. 2011, but I am willing to wager that ever since the 2008 crash, or thereabouts we have been plagued with economic slowdown resulting in a flat yield curve.  This can also be seen by the sideways movement in the Nifty EPS growth rate.

Nifty-analyzer-2

Use the Nifty valuation analyzer for more such insights.

Let us now look at the 10Y and 1Y bond yields and the difference between them from Sep. 2011. Both the right and left axis represent percentages.

Rbi rate cut-1
Source: investing.com

I am unable to find out the origin behind the sharp dip  in late 2011.  Notice the difference plotted in purple (right axis). The difference is barely positive and does not move much before the July 2013 crash.

In the months leading up to the crash the yields nose-dived. Which I think is because of heightened activity mainly in short-term bonds triggered by the depreciating rupee. Do correct me if I am wrong.

In July 2013, RBI hiked the short-term interest rate to stem the purchase of short-term bonds, reduce liquidity in the market and support the falling rupee. The above graph indicates this move with a sharp increase in 1Y  yield.

When the short-term rates increased, the FIIs suffered notional losses and made them real by exiting in panic. Banks redeemed from liquid funds to bolster  liquidity pulling down their NAVs

Suddenly the 1Y  yield was higher than the 10Y yield. RBI had 'inverted' the yield curve. Typically, short-term yields higher than long-term yields would imply a recession, but this was an artificial inversion created to save the rupee.

In the next few months, the difference between the yields got erased and as elections loomed, the equity markets picked up in the hope of a 'strong' government. Soon after the BJP government took over, inflation stabilized and began to drop.

There was an indication that rates will not be increased anymore and then there was the hope that it would be cut. With this hope, investors (of whom the FIIs are significant) started to buy both long-term bonds (to gain from the rate cut) and short-term bonds (to lock-in to the high rates. As a result, the yields plunged downward.

Yesterday, both the yields went down sharply in reaction to the rate cut.

As mentioned above, this is because, when rates fall, new bonds will be issued with lower coupon rates (interest rates), that is with lower yields. The existing bonds yields will be lowered to match the yield of the new bonds. To do this, existing bond prices increase.

As of yesterday, the 1Y bond yield (tracked at investing.com) is still higher than the 10Y yield. This means that we not out of the woods. That is, this rate is not a  sign that the economy has picked up.

The online yield curve maintained at Clearing Corporation of India is shown below for yesterday (red) and the day before (14th; blue) is shown below. Thanks to Rajendra Dixit for pointing me towards this resource.

Rbi rate cut-2

Notice the sharp lowering of the short-term yields in reaction to the rate cut. Other short-term bonds, not part of this curve plunged even lower (automated yield curve generator is coming soon). This is only to illustrate the effect of a rate cut. This represents data for two days. Dont read too much into it.

It is important to recognise that this rate cut (hopefully the first in a series of such cuts) means little because of the following reasons:

  1. Inflation in India depends on international oil prices and monsoons among other things. These are beyond our control.
  2. Stability of the rupee is important. This is a complex problem. Some factors depend  on how easy it is for the government to pass laws. Some factors originate outside the country.  The rupee has been 'stable' for just over an year now. So let us not get too comfortable.
  3. Both the above factors, if favourable, will sooner or later reflect in the rate at which earnings per share increases (hopefully!). When that happens, I can afford a smile and pray for the bull run to continue.
  4. Sooner or later, the 1Y yield will first drop lower than the 10Y yield and the drop even lower. At which time repo rate will be increased soon and yet another cycle of jubilation and despair would begin.
  5. This rate cut is certainly a step in the right direction. Although a journey starts with a step, it is only a step. There is nothing special about it.

It will take more cuts to ensure the long-term yield edges higher than the short-term yield. Hopefully, those cuts will come down the line gradually. Any sharp rate cut comes with the danger of a retraction, which will seriously hurt investor sentiment.

Why bother?  Why can't we ignore this noise and focus on our financial requirements and then move onto other things? Why must we jump up or down in reaction to a non-event which is part of a cycle anyway? Beats me.

If you can provide additional insights or would like to correct any of the above interpretations, please do so.

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12 thoughts on “The Rate Cut in Perspective

  1. bharat shah

    i think, your discussion is about direct investment in bonds. but i think, one should be careful before buying the idea that now long term debt funds are better, as it seems , the prices of such debt funds have taken this news already in account, as some of such funds already returned more than 7% absolute in last three months, so be vigilant, i think.

    Reply
  2. bharat shah

    i think, your discussion is about direct investment in bonds. but i think, one should be careful before buying the idea that now long term debt funds are better, as it seems , the prices of such debt funds have taken this news already in account, as some of such funds already returned more than 7% absolute in last three months, so be vigilant, i think.

    Reply
  3. Deepak

    Pattu,

    People piled into bond funds the last time when subba rao was the governor when supposedly the rate cut was imminent - check the inflows and the loses people took - as they say when everyone is expecting a rate cut , probably its already in the prices and the NAV's - IMHO the bond market is slightly more perfect compared to the equity market and inputs information into the prices.

    Reply
    1. freefincal

      Raghuram Rajan took charge in Sep. 2013. What you refer to must have occured a few months before July 2013. I guess that mere speculation as there was no evidence inflation was lowering at that time. All those guys must have taken a severe hit in the July crash.

      Reply
  4. Deepak

    Pattu,

    People piled into bond funds the last time when subba rao was the governor when supposedly the rate cut was imminent - check the inflows and the loses people took - as they say when everyone is expecting a rate cut , probably its already in the prices and the NAV's - IMHO the bond market is slightly more perfect compared to the equity market and inputs information into the prices.

    Reply
    1. freefincal

      Raghuram Rajan took charge in Sep. 2013. What you refer to must have occured a few months before July 2013. I guess that mere speculation as there was no evidence inflation was lowering at that time. All those guys must have taken a severe hit in the July crash.

      Reply
  5. ERI

    Hi Pattu,

    Attempting to share my garbled thoughts on this rate cut.

    Rather than demand - supply, bonds trade on signalling. If the yield curve is flat, that is so because the risk in short term lending has gone up, and hence lenders demand higher interest to compensate for the increased risk. If the economy is expected to be booming for short term future, the perceived lending risk goes down and the short term rates crash because more liquidity flows in.

    Hence if the near future economic scenario of a country goes bust, it is the short term rates that shoot up! Case in point - Greece in last few years.

    Secondly, repo rate is the rate at which banks borrow from RBI, so it works as a upper cap for rates. If the repo rate is cut, more liquidity is released in markets ( refer "Greenspan Put" ).

    Since repo rate impacts the rate at which banks can borrow, the repo rate cut also results in FD rates reduction.

    So basically repo rate cut increases liquidity, and thus repo rate cut signifies RBI is now comfortable with current and projected inflation levels to allow the market liquidity to increase. This shows shift in policy focus from inflation to growth.

    So this repo rate cut is a significant signal of RBI's changing stance from inflation to growth and hence equity markets acknowledged it accordingly.

    Reply
    1. freefincal

      Thanks for your insights. While I agree with you that this is a good sign, I will wait to rejoice when earnings grow. Also, a yield curve can flatten because long-term bonds are not sold.

      Reply
  6. ERI

    Hi Pattu,

    Attempting to share my garbled thoughts on this rate cut.

    Rather than demand - supply, bonds trade on signalling. If the yield curve is flat, that is so because the risk in short term lending has gone up, and hence lenders demand higher interest to compensate for the increased risk. If the economy is expected to be booming for short term future, the perceived lending risk goes down and the short term rates crash because more liquidity flows in.

    Hence if the near future economic scenario of a country goes bust, it is the short term rates that shoot up! Case in point - Greece in last few years.

    Secondly, repo rate is the rate at which banks borrow from RBI, so it works as a upper cap for rates. If the repo rate is cut, more liquidity is released in markets ( refer "Greenspan Put" ).

    Since repo rate impacts the rate at which banks can borrow, the repo rate cut also results in FD rates reduction.

    So basically repo rate cut increases liquidity, and thus repo rate cut signifies RBI is now comfortable with current and projected inflation levels to allow the market liquidity to increase. This shows shift in policy focus from inflation to growth.

    So this repo rate cut is a significant signal of RBI's changing stance from inflation to growth and hence equity markets acknowledged it accordingly.

    Reply
    1. freefincal

      Thanks for your insights. While I agree with you that this is a good sign, I will wait to rejoice when earnings grow. Also, a yield curve can flatten because long-term bonds are not sold.

      Reply

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