RBI SAYS, “AAO TWIST KARE!”
RBI kept on reducing repo rates and the banks kept on ignoring it; passing on some pittance as ‘rate cut.’ Thus RBI’s rate cuts never really percolated down to the common man and thus lending never really took off.
The RBI yesterday came up with a unique way to get the banks to lend more – Desi Operation Twist. RBI announced that it will buy longer-tenor bonds while selling shorter debt. Sounds familiar? That’s because its similar to what the US Fed Reserve did in 2011-12 to make its long term debts cheaper and spur lending.
RBI said yesterday that it has decided to conduct simultaneous purchase and sale of government securities under Open Market Operations (OMO) for Rs.10,000 crores each on December 23, 2019 (Monday).
It will purchase Bonds of 6.45% GS 2029, maturing in Oct 2029, aggregating Rs.10,000 crore. Simultaneously, it will be selling, using multiple price auction method, the following:
A few questions answered on this ‘Operation Twist’
Why is it called “Twist?”
That’s because on the yield graph, a twist is created - as the short-term yield curve trends up, the long-term interest rates trend down at the same time, creating a twist in the chart's trendlines.
Why the need to do this’Twist?”
RBI, by buying long term bonds hopes to push up the prices thereby bringing the yields down (prices and yields always move in opposite direction). And by simultaneously, by selling the short-term bonds, it will do the opposite – depress the price and push up the yields.
How will this help?
The idea is that by pushing down long term yield rates, it could help boost the economy by making loans less expensive, which in turn could spur buying of homes, car and entrepreneurship. People will keep less money in the bank as it will earn very little interest.
Has this worked in the US?
In the short term, like what we are currently seeing in India, yields on long –term bonds go down – thus that objective for now will be met. But in the USA, on the long term, Operation Twist drove down rates on Treasury bonds by only 0.15%, with little impact on either EMI rates or corporate borrowing costs. In USA, those in the financial community confer that Operation Twist was too weak to improve the economy or bring down the unemployment rate.
What is the co-relation between bonds and yields?
They both, the price of the bond, which is the face value of the bond is inversely proportionate to the yields. Imagine the price and yield sitting on a see-saw. When price goes up, yield will come down and when price goes down, yield will come down. This is probably the most simplistic way of understanding this concept.
What about interest rates and bond markets?
Interest rates and yields move in the same direction, so that naturally means interest rate and bond price move in opposite direction.
How to calculate bond yields?
It is simple math – coupon rate/face value of bond.
Suppose you have a Rs.1000 face value bond and coupon rate of 7%, then the yield is 70/1000 = 7%.
How to co-relate interest rate, yields and bond prices?
An increasing bond price means yields will be going down. And when will bond prices rise? When there is demand. And when will the demand for bonds rise? Demand for bonds rise when people seek safer havens – that is usually how this works. And demand drops when other markets are safer. At the end of it, even bonds at some point of time, reflect more of sentiments.
How do yields give an indication of the stock markets?
If yields go up, it means there is trouble on the horizon and this always indicates a negative market condition. Yield and risk go hand-in-hand. Higher the yield, higher is the risk – so you get paid as per the risk in the market.
How does this affect you as a trader and as an investor?
Bonds are traded in the market unlike a fixed deposit, which is why yields and interest rates need to be taken into account. When bonds are traded in an open market, yield will be the profit which you make on the purchase of bond. Thus when bond prices rise, yields will fall and that will make purchasing the bond in the open market much attractive as the face value would have got adjusted upwards to adjust the lower yield.
This is a good move by RBI and it can work only if more ‘Twists’ are followed in the months to come and that in turn will depend on the success of the operation on Monday.