Previous Year Question
Indian Government Bond Yields are influenced by which of the following?
Actions of the United States Federal Reserve
Actions of the Reserve Bank of India
Inflation and short-term interest rates
Select the correct answer using the code given below:
1 and 2 only
2 only
3 only
1, 2 and 3
Correct Answer: D
Detailed Solution
A bond yield is the return that an investor expects to receive by purchasing a bond at its prevailing market price. Bond prices and yields move inversely: when the market price of a bond rises, its yield falls, and when its price falls, its yield rises.
Statement 1 is correct.
The monetary-policy actions of the United States Federal Reserve influence global interest rates, capital flows, the value of the dollar and investors’ willingness to assume risk.
If the Federal Reserve raises interest rates, returns on US government securities may become more attractive. Foreign investors may consequently move funds from emerging markets such as India to US assets. A decline in demand for Indian government bonds can reduce their prices and raise their yields.
Conversely, lower US interest rates may increase demand for relatively higher-yielding Indian securities, potentially raising Indian bond prices and lowering their yields.
Statement 2 is correct.
The RBI’s policy interest rates, liquidity-management operations and Open Market Operations directly influence government bond yields.
An increase in the Repo Rate may raise short-term interest rates in the economy. Investors may then demand higher returns from existing bonds, causing their market prices to decline and their yields to rise.
When the RBI purchases government securities, demand and prices may rise while yields decline. When the RBI sells securities, their market supply increases, potentially placing downward pressure on prices and upward pressure on yields.
Statement 3 is correct.
Higher inflation reduces the real purchasing power of the fixed payments received from a bond. Investors demand a higher nominal yield to compensate for this loss. Rising inflation or inflation expectations therefore generally place upward pressure on bond yields.
Short-term interest rates also form an important basis for determining long-term bond yields. A long-term yield incorporates expected future short-term rates, expected inflation and a term-risk premium.
Government borrowing, the fiscal deficit, demand for government securities and market perceptions of risk can also affect yields.