With the pandemic behind us and the world learning to live with it, one would think we are out of the woods? Are we? It doesn’t seem so! In response to the pandemic, the Global Central Banks (CBs) had opted for an ultra-accommodative policy to support the economy. This easy money combined with supply-side bottlenecks due to the Russia Ukraine crisis has sent inflation through the roof. For instance, the US is experiencing inflation never seen in the last 40yrs; even in India, the CPI inflation has been tiptoeing with RBI’s comfort zone.
In a bid to contain inflation, the Global CBs have started to pursue aggressive rate hikes. The RBI, too, followed suit by announcing a 40bps hike in an off-cycle meet on 04th May 2022. Although this action caught the market by surprise, the markets had been pricing this policy event way before time, which was visible in rising yield.
The resultant dramatic rise in yields has got the investors worried and second guessing where the yields are headed! So let us look at how a balanced duration instrument like the 5yr G-sec (referred to as 5-YR henceforth) has typically behaved historically during rate hikes.
How Policy Changes Impact Investment Decisions
Currently (13th May 2022), the repo rate stands at 4.40%, while the 5-YR yields 7.02%. As seen historically, on average, the 5-YR trades at a spread of 50-60bps over the repo rate. Currently, the spread is at a whopping ~260bps, indicating that the market has priced in further rate hikes in the coming future.
Looking at the historical rate hike cycle may help us draw some inferences. We analyzed the historical data using month end values to eliminate noise.
The last decade witnessed two rate hike cycles, in 2013 and 2018. It was interesting to observe that during both the rate hikes significant run-up in the yield happened before/up-to the first rate hike. While post the first-rate hike, the yields either did not rise significantly or started declining.
As can be seen in the above table, during the 2013 rate hike cycle, the yields on the 5-YR started rising during May-Aug 2013 and then they peaked before the first rate hike. Similarly, during the 2018 rate hike cycle, the yield ran-up significantly before the first rate hike, only difference in this case was the yields inched up a little even after the first rate hike. While the observation during the 2013 & 2018 rate hike cycle are encouraging, it is essential to note that both the rate hike cycle were short-lived, and the quantum of hikes was small.
To increase our conviction, let us go back to the post GFC crisis, when the rate hike cycle lasted more than a year and the repo rate increased from 4.75% to 8.50%.
Before we deep dive into it, it would help to acknowledge that GFC was a black swan event and the policy action that followed was unprecedented. This rate hike cycle witnessed a total of 12 hikes, totaling 375bps. At the same time, the 5-YR yield rose by 346bps during Dec 2008-Oct 2011, and unlike 2013 or 2018 rate hike cycle, the yields did not peak-out around the first hike. However on closer analysis, one may notice that even though the yields did not peak-out by the first hike, but the yields has already risen up by ~200bps up to the first repo hike, this is 2/3rd of the total jump in overall yield. The rest 1/3rd jump happened in a lockstep manner.
Forecasting Market Reactions to Upcoming Policy Decisions
It is observed that, usually markets are forward-looking and factor in policy action ahead of the move. In the current scenario, the 5-YR G-sec has seen sharp run up as yield went up by more than 200 bps from July 2020 lows. What remains to be seen is whether the current rate hike cycle will be short-lived or more prolonged. In either case, if history repeats itself, one may infer that most of the run-up in yield is already done.
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