Bond spread squeeze major risk on Rupee:
10Y bond yield at sub 8% is good when there is long term comfort on inflation for steady headline CPI at 4-6%. Till then, India-US 10Y bond spread below 5.50-5.65% will hurt Rupee! There are lot of uncertainties around shift to sustainable low interest rate regime when issues around base effect upward adjustment on inflation, risk of reversal in commodity prices, improvement in twin-deficits and FII driven domestic liquidity etc are still not out of the way. With all these concerns on the radar, it is not prudent to expect street-smart FIIs to stay invested in Gilts at spread below 5.50-5.65% when US 10Y bond yield is expected to stay in extended stability at 2.15-2.40/2.65% through 2015. RBI (as custodian for price-stability of Rupee) is indeed concerned on downside risk on Rupee if bond market stays in excessive exuberance in anticipation of more than 50 bps rate cut in 2015. It is also visible that RBI is short of ideas to address this bond yield - Rupee exchange rate contra impact when its inflation outlook is not very optimistic below 6% in 2015. The choice therefore is either to allow extended rally in bond market at the cost of Rupee weakness beyond 63.35 or administer stability in 10Y bond yield at 8.0-8.25% and Rupee at 61.50-62.50. Stake-holders need to keep this in mind, going forward with caution note that RBI's preference is for ensuring price-stability in both Bond and Rupee markets.
Moses Harding
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