Debt is no longer in fashion - so go and buy bonds

The US debt ceiling has been increased with much drama. The fact that the ceiling would be increased before a bond maturity payout in the first week of August was not in doubt, as the US has too much pride in itself to default on debt for technical reasons.

In the bipartisan deal, the US raised the debt ceiling by $2.1 trillion and proposed a cut in spending (over a period of time) by $2.4 trillion. However, the bottomline is that the US will not loosen fiscal policy for a while, until sovereign debt issues die down.

The world will also follow the US in looking to bring down sovereign debt. The fact that high sovereign debt forced Greece into near default and took up its CDS (credit default swap) yields to 25 percent is worrying all governments with high debts.

It does not matter if debt is in local currency or foreign currency. The appetite of the market to absorb debt of highly-indebted countries is low, and unless there is a clear-cut plan of reducing debt down the line, the markets are not willing to listen. Hence bonds of Portugal, Ireland, Spain and Italy are all trading at higher levels of yields due to sovereign debt issues.

The reaction of the US 10-year treasury yield to the debt ceiling issue is enlightening. The benchmark treasury yield is trading at a year’s low of 2.75 percent. US bond investors are actually cheering the spending cuts and betting on deflation going forward as US growth will lag estimates due to lack of government stimulus.

The bond yields, at one-year lows, suggest that investors are not worried about the lack of a third QE (quantitative easing) by the US Federal Reserve (Fed). The Fed discontinued bond purchases after June 2011, when the second QE ended.

Back home, bond markets are definitely not cheering rising government debt. Ten-year government bond yields are trading at a multi-year high of 8.45 percent levels on the back of a continuous supply of bonds and rising inflation.

The government is borrowing around Rs 4,15,000 crore gross in fiscal 2011-12 of which almost half will be completed by this week. The government will have to raise the borrowing plan to meet its extra subsidy bill arising from rising crude oil prices. Crude oil prices have risen almost 20 percent over the past six months.

Inflation, as measured by the WPI (Wholesale Price Index), is trending at close to 9.5 percent levels and this has forced the Reserve Bank of India to tighten monetary policy. The central bank had raised the benchmark repo rate cumulatively by 325 basis points (3.25 percent) over the past 18 months to contain rising inflation expectations.

The Indian government does not have the stomach for widening the fiscal deficit. It has seen the repercussion on its own cost of borrowing as well as the negative effect high debt has on other countries, including the US. The government is also seeing the consequences of inflation. One of its key allies has lost an election due to inflation (DMK lost in Tamil Nadu elections in May this year with corruption and inflation being key factors in the loss). The government will do all it can to contain its fiscal deficit and its absolute level of borrowing.

Indian government bond yields will react positively to the government showing concerns on its fiscal deficit and its absolute level of borrowings. The RBI has done its job in raising rates to contain inflation expectations and if global spending cuts bring down commodity prices as growth slows down, inflation too will see a downward trajectory. Bond yields should take their cues from the rally in US treasury yields and start trending down.