Top 10 factors affecting fixed income market

Fixed income instruments are a series of cash flows. They carry a fixed rate of return and maturity period. Fixed income securities are issued by both, government and private companies. They can be short term or long term. Fixed income securities maturing before 365 days are known as money market securities. Long term fixed income securities have more than one year maturity.

The market is also divided on the basis of issuance- primary market and secondary market. The primary market is mainly active in terms of primary auction of government securities as well as issuances of PSU and private issuers. Therefore the primary markets are between issuers and investors while in the secondary markets the trading takes place between two investors. The fixed income markets are majorly institutional in nature.

Factors which affect the fixed income markets:

Inflation:
Inflation is a tendency for prices to rise continuously. The Central Bank has a tolerance limit for inflation. If the inflation is outside the limits of tolerance, the Central Bank will act appropriately. If the inflation rates are higher than the tolerance limit then the Central Bank will hike the repo rates and vice versa. In India, the CPI inflation is tracked for this purpose. The RBI has a tolerance band of 4% to 6% at present.

Fiscal Deficit
The Fiscal deficit as presented in the budget can be as per the FRBM Act (of 3%) or higher than the permitted. In the past 3 years, in India, we are higher than the permitted range on account of Covid spending. Due to the increase in fiscal deficit, the market borrowings also increased. The increased supply of bonds will tend to increase interest rates, in the absence of a new set of buyers.

Federal Reserve’s actions:
The rate action of the US Fed Reserve also impacts the rate decision of our Central Bank as the dollar is the reserve currency and it impacts our foreign currency due to the interest rate differential. Therefore, if the Fed Reserve raises rates upwards, the Emerging Market countries also increase interest rates in tandem.

The same is not however true while cutting interest rates. Most of the Central Banks across the world have all raised interest rates in tandem with the Fed Reserve.

Current Account Deficit
If the current account deficit is around tolerance limits of around 2%, it is considered fine. However an increasing CAD is bad for the economy as it can trigger a depreciation in the currency and thereby call for increase in interest rates.

Crude Oil Prices
Since India is a big importer of crude oil, if the price of crude oil increases, it causes the CAD to widen and therefore the market always keeps a close watch on the price of crude oil. This also leads to inflation in the long term and is therefore negative for fixed income markets.

In the last FY, the crude oil prices were around $88 per barrel on an average which has now decreased to $75 per barrel. This has helped the CAD positively and also contributed in softening inflation outlook.

Credit Offtake
If the demand for credit is strong, it will mean that the banks will not participate much in the government securities auctions and will maintain SLR which is just required and not excess. Since there will be less interest in the auctions, the interest rates will increase.

Stance of the Central Bank
Generally, the monetary policy committee gives a statement which gives out the statement on the interest rate stance- if the stance is ‘accommodative’ or neutral or ‘withdrawal of accommodation’ it gives the market a hint as to in which direction the interest rates are expected to move. Currently it is in the ‘withdrawal of accommodation’.

Liquidity supply:
The market can be in a liquidity surplus or deficit mode. If it is in surplus mode, then the interest rate are soft and vice versa. Therefore, if the RBI wants to raise the interest rate, it also sucks out the liquidity from the system as the policy pass on can be more effective.

Similarly, during the demonetisation, when the money supply increased in the banking system, the interest rates crashed as the demand for bonds far outpaced the supply on the back of humongous liquidity in the banking system.

FPI action:
When FPI purchase in the markets, there is an influx of foreign currency in the country and therefore it increases the rupee liquidity. When the FPI purchases bonds, the rates are expected to soften on the increased demand for bonds.

In 2013, when the Fed Reserve in the US signalled that they will be shrinking the Balance sheet, the US market went into a ‘taper tantrum’. Thus, the FPIs did not rollover the T-bills in India which had come up for maturity. This also caused the interest rates to rise. If there was a selling by them, it would have been worse in terms of rate action.

RBI Action:
When the RBI conducts Open Market Operations (OMO) ie it purchases bonds- it will help in softening the interest rates and vice versa. This has been helpful in the markets- when the govt borrowing was large as in the Covid years – with not much demand in the banking system- the RBI supported the borrowing programme through OMO purchase and helped keep the rates lower than it would have been.

Sometimes, the amount of OMO purchase/sale may be only token in nature- in that case- it is a rate signal. This helps give direction to the market – to discipline itself especially in an overheated market. At times- the RBI may use moral suasion to create the desired effect.

The above mentioned indicators can provide a good guide to the direction of interest rates and will be helpful for investment

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)