Role of Monetary Policy in Debt Markets
The debt market in India includes the long-term debt market and the short-term money market. Money market transactions have a maturity of less than one year, while bond market transactions have a maturity of more than one year. The monetary policy of the Reserve Bank of India (RBI) impacts both the long and short end of the debt market.
The monetary policy and the bond market are closely related because the rate change directly affects the bond prices. RBI’s monetary policy includes rates, liquidity and policy for investment in government bonds by banks and Foreign Portfolio Investors (FPIs). Let’s understand further how monetary policy affects the debt markets.
What is RBI’s Monetary Policy?
Monetary policy is a policy formulated by the RBI, that deals with monetary matters in India. This policy includes the actions taken to regulate the supply of money and the cost of credit in the economy. This policy also takes care of the distribution of credit amongst the citizens along with the lending and borrowing rates. Monetary policy plays a vital role in promoting economic growth in developing countries like India.
The following paragraphs covers how monetary policy affects the debt market in various ways.
Rate Announcements and Bond Markets
The market interest rates and bond prices have a negative relationship. Simply put, bond prices tend to fall when the rates go up and vice versa.
For instance, you hold a bond with an 8% coupon with a maturity that is seven years away. Let’s say RBI cuts the rate by 2%, here you are at an advantage because your 8% coupon rate looks attractive as the new bond issues would get 2% lower returns. A coupon is the interest payment that a bondholder receives from the date of issuance to the bond’s maturity date in the world of finance. If you hold government bonds or funds predominantly investing in government securities (gilt funds), you stand to benefit from the falling interest rate. As a result, gilt funds outperform during falling interest rate scenarios.
Rate Expectations and Debt Markets
Regarding the bond markets, especially long-term bonds, the rate expectations matter more than the actual rate announcements. It is because the movement of the 10-year benchmark acts as an indicator of what can be expected from the RBI’s monetary policy.
Alt text- India Government Bond Generic Bid Yield 10 Year
For example, consider the above chart that reflects the movement of 10-year bond yield for the period of one year. Here are the three instances. The first time the RBI hinted at a change from an accommodative policy to a neutral policy was in February 2017, and as can be noticed, there was a sudden spike in bond yields. However, the yields started to fall again after April 2017 as lower inflation, and the US Fed built expectations of further rate cuts by the RBI, which again reflected in the falling bond yields. After June 2017, when inflation reached its lowest point, the traders were betting on the end of the rate cut cycle. In the next six months, the bond yields saw an upside of 88 basis points (100 basis points equals 1%) even after the RBI did not change the rates.
Market Liquidity and Debt Markets
The RBI provides signals on liquidity apart from the outlooks on rates. The RBI tweaks liquidity into the system with its open market operations (OMOs). When RBI hints at more liquidity in the system, the short-term rates go down and vice versa. Therefore, liquidity management is vital in shaping the yield curve of the bond markets.
Triggers Demand and Supply of Bonds by Banks and FPIs
Banks and FPIs are major investors in the government bond issues. And typically, they decide their strategy to purchase bonds which depends on the outlook for rates and the bond yields. Banks prefer a falling interest rate as it results in the capital appreciation of their bonds which gives them a chance for the banks to book treasury profits. A falling interest rate allows the government to increase debt at lower yields. On the other hand, FPI considers two things. First, they check the spread of the Indian benchmark yield over the yield in western markets such as the US. Say if Indian bonds are trading at a premium of 400 basis points, typically more than the US benchmark yields, which are enough to attract the FPIs. Secondly, the monetary policy provides a currency outlook which may be critical for the FPIs. The monetary policy of the RBI has crucial implications for the debt markets in terms of rates, liquidity and institutional investors.
Frequently Asked Questions (FAQs)
- What is RBI’s monetary policy for 2023?
On the basis of an assessment of the current and evolving macroeconomic situation, the MPC (Monetary Policy Committee) at its meeting on February 8, 2023 has decided to increase the policy repo rate under the LAF (Liquidity Adjustment Facility) by 25 basis points to 6.50 per cent with immediate effect.
2. What is the role of monetary policy?
The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth.
3. How many times does the RBI announce monetary policy?
The RBI announces monetary policy once every six months. In addition, RBI is required to publish a document known as the Monetary Policy Report, which consists of the sources of inflation and the forecasts of inflation in the next 6-18 months.