In an unusual occurrence bond markets reacted very slowly to the central bank’s credit policy move of keeping interest rate stable. The 10-year bond market yield closed slightly higher at 6.431 percent on the day the policy was announced. But today it gapped up at 6.751 percent and has traded higher since the opening bell. It currently trades above the opening price at 6.806 percent.
The late reaction in the bond market was transferred to equity markets, especially to banking stocks. Most of these stocks recovered from the initial jolt immediately after the policy was announced. They opened flat today, but after an initial pause they fell marginally.
A rising interest scenario is particularly bad for public sector banks. A substantial amount of profit in the December quarter for these banks is expected to come from treasury profits. This will help them hide the poor performance from general banking activities in December quarter.
But the advantage these banks had in December quarter is unlikely to continue in the current quarter especially on account of rise in bond yields. Public sector banks are still reeling under pressure from a slow offtake of credit and the poor quality of its assets. Flush with deposits on account of demonetisation, these banks are investing their money in government bonds rather than lending in the markets.
To make matters worse, these banks are undercapitalised. They depend on government to infuse capital, but in the recent Budget Finance Minister allocated only Rs 10,000 crore under the Indradhanush scheme. Under this scheme, the government is expected to pump in Rs 70,000 crore over four years beginning FY16. In FY17 Rs 22,000 crore was infused into 13 public sector banks.
RBI in its policy had clearly mentioned that public sector banks need to be capitalised fast so that they can get over their non-performing asset issue. Unless these banks are properly recapitalised there is little hope for these banks to compete with private sector players.
What seems to have spooked the market more than a pause on interest rate is the central bank’s stance of moving from an ‘accommodative’ to ‘neutral’ one. This means that further rate cuts are ruled out in the short-term.
Adding to the bad news was RBI’s inflation forecast. The central bank indicated a forecast of 4.5-5 percent in the second half of FY18 which is against its target of 4 percent. With a hawk-like focus on inflation it is very unlikely that the central bank would like to cut interest rates in future unless inflation comes down to more manageable levels.
Banks are bracing for tough times.