How bond yield in US affect India

How bond yield in US affect India

Subject: Economy

Context:

With the US Federal Reserve increasing interest rates aggressively to curb inflationary pressures, the yield on US 10-year bonds surged to 4.163%.

Concept:

What is yield in the context of a bond?

• Yields are the returns from investing in a bond.
• A bond’s yield is based on the bond’s coupon payments divided by its market price; as bond prices increase, bond yields fall.
  • Example-Let’s say you have a $1,000 bond that has an annual coupon payment of $100, and it’s selling near par, for $1,010. Its yield is 9.9% ($100 / 1010). Now, let’s say the bond’s price jumps to $1,210. Its yield falls to 8.3% (100 / 1210).
• Government bond yields are indicative of a country’s inflation and interest rate expectations.
  • During periods of high inflation, newer debt issuances are compelled to offer higher yields-Rising inflation pushes bond prices down, thereby pushing yields higher.
    •  As inflation rises, central banks will increase short-term interest rates in an effort to cool down the economy. Additionally, rising inflation expectations lead to an increase in long-term rates, which are largely determined by market activity. The inverse relationship between interest rates and bond prices means that higher rates equal lower bond prices
  • As interest rates rise, bond yields rise– When the risk-free rate of return rises, money moves from financial assets to the safety of guaranteed returns i.e., if the interest rate rises from 2% to 4%, a bond yielding 5% would become less attractive. The extra yield would not be worth taking on the risk. Demand for the bond would decline given supply. Thus, bond price falls and the yield would rise until supply and demand reached a new equilibrium.

What is fuelling the rise in US bond yields?

• Quantitative tightening–Inflation in the US has been on a steady rise– to counter this, the US Federal Reserve has been raising interest rates aggressively has resulted in the bond

Impact on India?

• Capital outflows -The comparative improvements in the US capital markets lead to foreign portfolio investors (FPIs) withdrawing from the Indian capital markets. Higher bond yields reduce the attractiveness of equity markets as against fixed income securities.
• Currency depreciation-The net outflow of dollars leads to the rupee depreciation.
• Imported inflation-Rupee depreciation has also led to landed costs of crucial imports rising and leading to cost-push inflation in the country.
• Rise in domestic bond yield-Given the capital outflows demand for the bond would decline given supply. Thus, bond price falls and the yield would rise until supply and demand reached a new equilibrium.

What is the way out of this situation?

• To limit rupee depreciation, the RBI continues selling dollars in the foreign exchange market.