How RBI Caught the Bond Market By Surprise

Mon, 12 Dec Pre-Open

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Equity is not the only place where things get interesting. The bond market gets its fair share of excitement.

The bond market is the place where bonds are traded. A bond is a security that pays its holder a fixed sum on a regular schedule for a fixed term. Bonds are debt securities. Bond investors are lenders; bond issuers are borrowers. To issue a bond is to borrow money from investors for a fixed term at a fixed interest rate. At the end of the term, the issuer returns the principal portion of the loan.

The bond market moves when expectations change about economic growth and inflation. Investors decide how much to pay for a given bond based on how much they expect inflation to erode the value of those fixed payments. So the higher the inflation, the lesser bond investors will pay for bonds. The lower they expect inflation to be, the more they will pay.

After demonetisation, everyone was expecting rate reduction. The rationale was simple. The rate reduction would boost the economy which was slowing down due to currency withdrawal. The RBI slashed its growth forecast for FY17 by 50 basis points to 7.1%, and inflation was in a downward spiral.

Not to mention that investment was depressed and the Purchasing Managers' Index confirmed the drop in demand. These validations created a strong signal for a 25 basis point cut. Some even went to the extent of betting on a steep 50 basis points cut.

But the bond market forgot one thing - Expect the unexpected from the RBI.

Bond traders got a rude shock on Wednesday when their best-laid plans went up in smoke after the RBI surprised us with unchanged policy rates.

So, what did the bond market miss?

One, the bond market missed the momentum of core inflation. Even RBI governor Urjit Patel pointed this out during the media interaction.

Second, since demonetisation is supposed to be a temporary phenomenon for the economy, the monetary policy stance doesn't warrant a change. This is what the monetary policy committee (MPC) considered when all of its six members voted to keep rates unchanged.

And this is how the bond market was caught on the wrong foot. The bond market thinks the rate cuts are just around the corner. We just have to wait and see.

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