Spike in May retail inflation leads to drop in G-Sec prices

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Government Securities (G-Sec) prices dropped on Tuesday as the retail inflation reading for May 2021 spiked above the monetary policy committee’s upper tolerance threshold of 6-6.30 per cent against 4.2 per cent in April.

Given that MPC tracks the retail (consumer price index/ CPI-based) inflation gauge closely, if the reading sustains above the 6 per cent mark for another month or two, it will have to do a hard re-think on its ultra-loose monetary policy to tamp down inflation.

Price of the 10-year G-Sec (coupon rate: 5.85 per cent) came down by about 26 paise to close at ₹98.64 (previous close: ₹98.895), with its yield rising 4 basis points to 6.04 per cent (previous close: 6.00 per cent).

Price and yield of bonds are inversely related and move in opposite directions.

‘Double whammy’

Madan Sabnavis, Chief Economist, CARE Ratings, said, “The CPI inflation number at 6.3 per cent is higher than our expectation of 4.9 per cent and is a kind of double whammy for the economy coming as it does over a sharp increase in WPI (wholesale price index-based inflation) by 12.9 per cent.”

He emphasised that high CPI inflation will be a concern for the Reserve Bank of India (RBI) as it is higher than their estimate of 5 per cent.

“Though the stated policy is that growth is more important, which means that repo rate will not be touched, it will be a nagging issue nevertheless especially if inflation remains in this region. We expect it to be around 5.5-6 per cent in next couple of months,” Sabnavis said.

Price of the G-Sec maturing in 2026 (coupon rate: 5.63 per cent) fell 42 paise to close at ₹99.94 ( ₹100.36), with its yield rising about 10 basis points to 5.64 per cent (5.54 per cent).

Price of the G-Sec maturing in 2035 (coupon rate: 6.64 per cent) too declined 42 paise to close at ₹99.94 (₹100.36), with its yield rising about 4 basis points to 6.64 per cent (6.60 per cent).

Suyash Choudhary, Head – Fixed Income, IDFC AMC, observed that the May CPI print will likely on the margin push up the importance of inflation in the growth versus inflation trade-off for RBI.

“This doesn’t necessarily mean that the central bank will start to respond to this right-away. However, the bond market may step up speculation with respect to the shelf-life for RBI’s current ultra-dovishness.

“This may make the task of dictating yields to the market that much more difficult for the central bank. At any rate, in our base case view, RBI would have started to dial back on its level of intervention at some point and we were budgeting for a gradual rise in yields overtime,” he said.

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What is inflation-adjusted return – The Hindu BusinessLine

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A phone call between two friends leads to a talk about inflation-adjusted returns.

Akhila: What are you up to, Karthik?

Karthik: I was planning to buy a television set for ₹50,000. But I later changed my mind to save and invest that amount to buy a better version next year.

Akhila: I hope inflation doesn’t eat into your returns.

Karthik: What do you mean?

Akhila: A few economists expect inflation to rise going ahead. If that happens, your inflation-adjusted returns can be low or even negative.

Karthik: Can you explain that?

Akhila: If you invest that ₹50,000 at four per cent p.a. in a fixed-income instrument, your investment will be worth ₹52,000 by year-end. Say, the average inflation over the next one year is six per cent and the price of the TV set which you decided not to buy, becomes ₹53,000. Let alone buying a better version, your investment amount won’t be sufficient to buy even the current model.

Karthik: Ouch!

Akhila: Inflation-adjusted returns, also called real returns takes into account the inflation rate while calculating the return on an investment.

Karthik: How do I calculate real returns?

Akhila: You can simply subtract the rate of inflation from the return on your investment. In the above example, the real return on your investment would be -2 per cent. That is, 4 per cent return minus the inflation rate of 6 per cent.

Karthik: That’s pretty simple.

Akhila: The above formula gives an approximate rate of real return. To be precise, you can use the formula — ((1+return)/(1+inflation rate)) – 1.

Karthik: Are there any savings instruments in the market that offer returns linked to inflation?

Akhila: There used to be inflation-indexed bonds but they are no longer available.

Karthik: Equities would give higher returns, right?

Akhila: Equity is said to deliver inflation-beating returns in the long-run. But remember, for the sake of earning higher inflation-adjusted returns, you should not go for investments that do not fit your risk appetite.

Karthik: What are the alternatives in the fixed income space?

Akhila: You can consider floating-rate instruments, coupon rates on which are linked to interest rate movements in the economy, which are a play of inflation as well.

Karthik: I remember reading the Simply Put column in BL Portfolio a few weeks back that talked about floating rate instruments such as Floating Rate Savings Bonds 2020, the PPF and the Sukanya Samriddhi Yojana.

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