Bond yields are down and equities are down, which will turn?
RBI maintained policy rates status quo in its policy review on the 16th of December and signaled that further policy actions will be that of rate cuts. The reaction of equity markets and bonds markets were completely different from each other. Equities tanked with the benchmark Sensex falling by over 3% from intraday highs while bond yields fell with the benchmark ten year bond, the 8.79% 2021 bond seeing yields down by 13bps over the day. Ideally falling bond yields should be positive for equities, but the negative reaction of equity markets to the policy suggest that more was expected from the policy by equity investors in terms of a cut in CRR (Cash Reserve Ratio).
Bond yields have fallen almost 50bps from highs over the last one month. RBI bond buying and expectations of rate cuts in 2012 have driven down bond yields. Equity indices on the other hand have fallen by close to 8% over the last one month, with the last 3% fall happing post the policy review. The divergence of the equity and bond markets suggest that equities and bonds expect economic growth for 2011-12 to fall sharply and RBI has to start cutting rates aggressively in 2012 in the face of slowing economy.
RBI has indicated in the policy review that it will continue with OMO (Open Market Operations) bond purchase auctions to infuse liquidity into the system. RBI has held three bond purchase auctions over the last four weeks and has bought bonds worth Rs 24,000 crores in the auctions. RBI is likely to hold three or four more auctions of Rs 10,000 crores each to bring down system liquidity from a negative Rs 85,000 crores. RBI bond buying is positive for the bond market as it helps tide over the government bond supply through government borrowing program. The government is scheduled to borrow Rs 99,000 crores over the next two and half months.
Equity investors are unwilling to look at the impact of rate cuts that bond markets are factoring in. Equity markets at present are worried on the weakness in the Indian Rupee (INR) affecting portfolio flows into the country. The INR fell to its all time lows on the 15th of December prompting the RBI to intervene with policy measures to stem further falls in the currency. Weak INR hurts profitability and repayment capacity of companies that have exposure to US Dollar debt, and Rs 33,000 crores of FCCB (Foreign Currency Convertible Bonds) are due for maturity in the next one year. Equity markets are also worried on the quality of bank balance sheets if a growth slowdown occurs. The BSE Bank index fell over 3% post the policy despite a rally in bond yields. Corporate profitability will take a hit on the back of a slowing economic growth and going by advance tax number for December 2011, which was almost flat year on year, corporates are unlikely to show improved performance in the coming quarters.
The question to ask going forward is will equity markets follow bond yields and rally or will bond yields follow equities and fall? The hope is that the former happens, but for that to happen it will take a while as rate cuts take effect in the economy and this happens with a lag.