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Impact of Inflation on Bonds

Inflation is a macroeconomic measure, used to determine an increase in the price of goods and services. The rate of increase in the price of commodities over a period of time is analysed to understand the trend in the pricing. It is basically a loss of purchasing power of a currency due to a hike in rates of different goods and services. When inflation climbs faster than usual, it can rattle consumers who aren’t expecting to pay higher prices for fuel, groceries, clothing, and numerous other products and services.

Inflation typically occurs during periods of economic strength, which forces increases in the costs of wages, merchandise, and commodities. If the money supply grows too big relative to the size of an economy, the unit value of the currency diminishes; in other words, its purchasing power falls and prices rise. More jobs and higher wages increase household incomes and lead to a rise in consumer spending, further increasing aggregate demand and the scope for firms to increase the prices of their goods and services. When this happens across a large number of businesses and sectors, this leads to an increase in inflation.

History of Inflation in India:

During the observation period from 1960 to 2021, the average inflation rate was 7.5% per year. Overall, the price increase was 7,700% An item that cost 100 rupees in 1960 costs 7,700 rupees now. For March 2023, the year-over-year inflation rate was 5.8%. In the past one year we have seen inflation rates correcting and were 4.3% in May 2023.

Inflation Rate

Intervention by the RBI to control Inflation

In India, the Reserve Bank of India monitors inflation closely. The central bank has set up a target inflation rate and will work towards achieving the same by amending the repo rates. RBI’s target inflation rate is 4%. Since May 2022 RBI has been increasing the repo rates continuously to curb inflation. Surprisingly, April-23 and June-23 RBI did not hike any rates. The US Fed hiking 25bps also built up an expectation of a similar move by our Central Bank. The market sentiment believed that if this hike would happen, it would be the last of its kind for a while. The Repo rate would have peaked out, and we would see rate cuts by the end of the year or early next year.

May-23 inflation rate reduced to 4.3%, from, 4.7% in April, 5.7% in Mar-23 and 6.4% in Feb-23. Now with the inflation reducing we have to wait and watch, whether Central Bank will announce a rate cut or take yet another pause.

Inflation and Repo Rate

Time Lag Effect: It can be observed that there is a negative relationship between Repo rates and inflation. But this comes with a “time lag” Once the repo rates are increased, we see the inflation rates reducing in a few weeks’ time.

Like RBI has been continuously increasing its policy rates since May 2022. We see a time lag till the inflation rates start showing inverse traction after Sept 2022. Even when RBI took a pause on rate hikes in April 2023, we saw a fall in inflation rates on account of the effect of previous rate hikes.

What impact does inflation create on bonds?

Bonds are known for their stability due to the fixed certainty of their returns. When an investor buys a bond, the rate of return is fixed irrespective of the inflation changing during the tenure of the bond. But the interest rates are hiked to control inflation. This leads to newer issues of bonds, coming with a higher rate of interest to match the increased rates. This leads to the existing bonds’ prices falling to match the yields of the new bond. Vice-versa if the inflation rates are reducing and there is a rate cut, newer issues happen with lower interest rates. This will lead to a rise in the prices of existing bonds due to their higher returns.

Thus, interest and price of bonds have an inverse relationship. Since inflation rates affect the interest rates in the economy, it will affect the bonds yields, in turn affecting the bond prices.

The different categories of bonds will have different inertia to the change in inflation. Usually, G-sec and AAA-rated bonds show slow traction compared to the lower-rated bonds, which are expected to be more volatile.

The continuous increase in the repo rate results in a decrease in the inflation rate, which subsequently leads to a decline in the yield on Government securities (G-Secs). The G-sec yield rallied from 5.7% around July 2020 up to 7.46% in February 2023. Since then, we saw a drop of almost 45bps with G-sec at 6.987% in May 2023. This correction is a consequence of a drop in inflation from Feb-April and a pause in rate hikes by the RBI. Now the market sentiments a rate cut by the RBI as the inflation rate lowers and moves towards the target rate of 4%.

G-Sec and Inflation Rate

Liquidity & Inflation

Inflation reduces the real value of money and thus makes the liquidity constraint more binding. An increase in liquidity is required to cover inflation and GDP growth. Most commonly, quarterly or annual advance tax payments draw liquidity out of the system as a lot of liquid money gets locked with the government. Lack of liquidity will have a direct impact on the bond market. Demands fall, leading to prices getting corrected. The RBI amends the monetary policy to maintain a balance of liquidity in the economy along with keeping inflation in check. An increase in liquidity in markets also triggers inflation, hence needing a constant check by the Central Bank.

Closing Thoughts

In conclusion, understanding the impact of inflation on bonds is crucial for investors, policymakers, and the economy. As inflation increases, the value of money decreases, leading to higher prices for goods and services. This affects both consumers and businesses.

Global inflation has a stronger impact on the stock market compared to bonds, including government securities and corporate bonds, which offer stability and protection against inflation. By considering inflation, interest rates, and bond prices, stakeholders can make informed decisions to navigate the effects of inflation on financial markets.

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