On Wednesday, July 12, 2023, data from India showed retail inflation for June sped to a three-month high of 4.8%, beating all market expectations.

The same day, a few hours later, data from the US showed CPI inflation there was at 3% for June, and it printed below most market expectations and at the slowest pace of increase in two years.

How would you have expected the Indian bond market to have reacted?

Instinct would be to say Indian bond yields will rise as inflation comes in much higher than expected. Such a reading, due to a sharp rise in food prices, including those of vegetables, may or may not prompt the Reserve Bank of India to raise interest rates, but it would definitely prompt it not to cut them anytime soon, as was hoped by several traders.

On the other hand, US inflation is expected to prompt the US Federal Reserve to still hike rates in July but force it to reassess the need for more hikes after that.

Indian bond yields fell, reacting to the US inflation rather than the Indian one.

The 10-year yield fell to a two-week low of 7.06% Thursday on expectations that an early end to Fed’s rate hiking cycle would allow the RBI to consider rate cuts here sooner.

Ever since the RBI announced a hawkish pause in April and maintained the same posture at its next meeting in June, the Indian bond market has been mostly reacting to the developments in the US.

The market, which was expecting the RBI to cut interest rates in October, has since reconciled to the central bank holding the repo rate steady at 6.5% for the remainder of the financial year.

The RBI is worried that Indian inflation and inflation expectations could again flare up if the monetary policy is loosened via rates or via easy liquidity.

The bond market doesn’t have too many domestic cues to lean on for big positions. The market believes that Fed stopping interest rate cuts and adopting a more dovish stance will be a necessary condition for the RBI to loosen its own policy in India. Consequently, the bond market has been moving in narrow trading ranges depending on the developments in the US.

Prior to the June policy, the bond yields were in a 6.96-7.02% trading range on the 10-year. After the MPC disappointed the market by maintaining its hawkish pause, the trading range shifted to 7.00-7.05% and then to 7.05-7.10%, and until the release of the US inflation rate, the range was 7.10-7.15%. The 10-year had touched an intraday high of 7.17% on July 7.

And most of the movement in yields was based on the developments in the US market and how each economic data release changed expectations around the Fed’s likely moves.

The small trading ranges are within the broader range of 7.00-7.25% was expected for the remainder of the year for the 10-year paper. The outlook is not that bearish as RBI is believed to have already taken the repo rate to the peak, and the Fed has taken its policy-setting rate near its peak. There is nothing to cheer about immediately for the market either, as the central banks are still hawkish and are threatening to hike more: While the RBI says it is ready for more action, the Fed has guided for two more rounds of hikes till December.

Unless the RBI surprises the market with even more hawkishness in August, the broader range of 7.00-7.20% is likely to prevail. Even if the RBI announces a neutral stance in October, the 10-year could stay above 7.00%. Many banks are looking to book profits with each down move of the yields.

Short-Selling

How does one trade this market?

Even within the broader range, a set trading behaviour has emerged in the last 5-6 weeks. Several traders would enter into short positions early in the week and cover those positions at auction or through repos.

There is no secular demand for government bonds from any segment of investors, which was the case in March after the Budget and in the April-June quarter. The heavy buying seen from mutual funds and insurance companies seems to have tapered off since June.

Most banks are now looking to sell the bonds they bought at the auctions earlier this year whenever the yields tend to soften, mirroring US yields.

The short positions and the covering at auctions are also keeping the market in a narrow range. Yields are expected to gradually inch up unless there is a strong impetus to the market in the form of a data set that could brighten the chances of the Fed turning dovish. But US data sets have been inconsistent, and the jobs data, in particular, has not softened enough to force the Fed to stop raising rates immediately.

No surprise then that the Indian bonds have reacted to US inflation rather than the Indian price rise.

Short-trading and covering have been helping traders make mild profits in the market that seems to be in a limbo. This game plan will likely be in play until clear guidance emerges from the Fed.

The Federal Reserve will announce its rate decision on July 26. For now, the market believes it will hike the rate by 25 basis points to 5.25-5.50% and end its rate-hiking campaign after that. The fall in US and Indian yields in the last two days reflects that.

But how would the yields move if the Fed takes a leaf out of RBI’s book and it, too, announces a hawkish pause, again only for the August meeting, and then keep the doors open for more hikes till December?

The limbo gets longer.