Falling oil prices pulls down bond yields

Falling oil prices pulls down bond yields

by 5paisa Research Team Last Updated: Jun 21, 2022 - 05:54 pm 24k Views

Why are bond yields falling in the last few days. Normally, you would expect that a hawkish stance by the RBI and the Fed would boost the bond yields higher. India has one more reason. Fiscal deficit is gradually running ahead of itself and that means more borrowings. That is also a strong reason for higher bond yields. However, what is happening in the last few days is exactly the opposite. The bond yields are now lower by around 10 basis points and this fall in bond yields can be largely attributed to the sharp fall in oil prices. 

Recently, the softening of crude prices boosted the domestic Indian rupee marginally. It has regained some of its lost ground after going well beyond 78/$, although it is hard to say if this can be sustained. At the same time, the yield on the 10-year benchmark 6.54% 2032 paper fell sharply from 7.6% to 7.44%. As oil gets cheaper, the trade deficit gets lower and that would mean less pressure on borrowings and the fiscal deficit. That is positive for bond yields, which has now come down sharply by 10-12 basis points in this week.

In the previous week, the prices of Brent crude futures slumped 7.3% while the West Texas Intermediates (WTI) futures plummeted more than 9% in the week. The oil prices fell after there were concerns that the spate of rate hikes and the sustained hawkishness would result in a sharp global slowdown. In its recent Fed statement, the governor hinted that the US growth could be lowered from 2.8% to 1.7% in 2022 and could be low even in 2023. That could trigger a global slowdown and depress the prices of crude oil substantially. 

The fall in crude oil prices, especially in the current context, is generally a trend reflective of disinflation in commodity prices. This leads to lower demand for money and hence tapering of bond yields. Also, the feeling in the market is that if the slowdown commences then neither the RBI nor the US Fed can afford to stay as hawkish as they are sounding today. They may be forced to do a course correction as they did in the case of COVID 2020 and may have to suddenly shift to cutting rates rather than hiking rates. That may happen with a lag.

India’s crude oil basket hit a 10-year high of $121 per barrel, but that could taper if the impact of Russian oil imports is also factored in. This had significantly increased upside risks to inflation and current account deficit. However, things have changed ever since the R-word has hinted at a recession in the global market. A recession is never a good time for high oil prices or for high bond yields. While these ideas are yet to crystallize, the lower bond  yields are reflective of the concern in the market that growth will eventually slow.

The wager at this point is that eventually, concerns over global growth slowdown could prompt central banks to scale down tightening plans. When such tightening plans are scaled down, the impact will be seen in the form of lower yields and that is what is visible today. We could have an inverted yield curve dichotomy wherein the short end rates are going up but the long end rates are going down. This is due to uncertainty over the distant future and people unwilling to commit funds to the longer end of the yield curve.

While the latest retail inflation number is still above the RBI outer tolerance limit of 6%, the rate of inflation has come down yoy and that is a positive signal. But for now, it is the recession fear that is pulling the bond yields lower. 

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