Inversions of the US curve have been most sensitive to rupee debt in the past, and it is likely that this time will be no different. A Bloomberg study analyzed four episodes back in 2005. In each instance, India’s benchmark yields climbed an average 11 basis points in the 10 days before longer-term US rates fell below those on shorter-dated maturities.
The latest danger is the threat of a US recession Indian bondsIn June, benchmark yields rose to their highest levels in two years after a weakening rupee. A slowdown in the world’s biggest economy may exacerbate the pressure from outflows, after global funds sold the notes for five months through June.
“In India’s case, the sense is that a sharp selloff in rupee bonds will dominate initially — as the capital outflow reflex imposes dominantly,” said Vishnu Varathan, head of economics and strategy at Mizuho Bank Ltd. in Singapore, referring to a US recession scenario. “Downside risks to EM Asia currencies mean that foreign investor confidence could be sharply declining.”
Indian bonds fell in tandem to a fall in the rupee. As a result of rising commodity prices, the currency is hovering at a record low against USD. This inflates inflation and increases the subsidy bill. Options market prices in a 64% chance of the rupee falling to 82 per greenback within the next six months, compared to around 79.6 right now.
Even worse, the government is planning to sell 14.3 trillion rupees ($180billion) of bonds this fiscal. Investors counting on the central bank’s help in this regard may be disappointed after a report from Citi last week noted that excess liquidity will limit its ability to conduct outright bond purchases.
In the short term, rupee bonds may not see much relief. Overnight indexed swaps are pricing in another 150 basis points of rate hikes from the Reserve Bank of India over the next 12 months as retail inflation has remained above the central bank’s 2%-6% target for six straight months.
The following table displays the changes in 10 year emerging Asia yields to Treasury curve inversions in four cases since 2005.