Bond markets need a reality check

Government bond markets have responded positively to the Union budget. The benchmark ten-year bond yield often used as a reference rate for other bonds and loans has dropped by 8 basis points (a basis point is a hundredth of a percentage point).

Yields are inversely related to bond prices and a drop in yields of this quantum corresponds to a fairly healthy rally in the bond market. The optimism has ridden essentially on back of the lower-than-expected fiscal deficit ratio for 2011-12 projected in the budget (4.6 per cent of GDP instead of the 4.8 per cent that was widely expected). Since government funds the fiscal deficit by borrowing from the market, the quantum of bond issuance is also lower than what the markets had factored in.

Bond prices follow exactly the same principle as onions - reduced supply pushes up prices. In this case, the anticipation of a lower supply of bonds from the exchequer in the coming fiscal year has pushed their prices up.

Perhaps bond markets need a reality check. Analysts of every hue and persuasion are questioning the credibility of the fiscal arithmetic. They argue that while the revenue targets are a trifle aggressive, the allocations for expenditure are pitiably small.

Thus, the prospect of the deficit going considerably over the target is somewhat strong. The corollary is that the government's cash calls on the bond markets over the year are likely to be higher than budgeted.

As bond supply increases, prices will fall and yields could climb. The counter argument is that even if the government were to borrow more, it would choose to do it towards the end of the fiscal year and not towards the beginning. Thus for the next six months, at least, the markets have breathing space.

Besides, the government could find other ways to fund its additional funding needs - dipping into unspent cash balances carried over from the current year, borrowing from the pool of small saving schemes and using external assistance and multilateral funding to bridge the fiscal gap.

The exchequer has incidentally relied on these non-market sources of financing quite heavily this year (2010-11). The ratio of market borrowings to the fiscal deficit has dropped to 83.5 per cent compared to an earlier average of over 90 per cent. A fiscal overrun thus need not necessarily mean additional borrowings.

The upshot is that the bond and credit markets could just be entering a sweet spot in which the strain of the last few months (short-term deposit and lending rates moved up by a hefty 3 percentage points in the last three months) dissipates.

Going forward, interest rates could rise more gently and this could have a positive implication for both investment and consumption spending. The government will of course benefit as its average borrowing cost will be low.

The party-pooper could be oil prices. If they remain high as a resolution of the crisis in the oil-producing world remains elusive, it is bound to impact on domestic inflation.

If inflation begins to climb again as the primary and secondary effects of fuel price increase, yields and interest rates could move up again. It will not take long for the fickle bond markets to forget about the payoff from fiscal rectitude and start fretting over inflation yet again.