According to the Mundell-Fleming Impossible Trinity theory, an economy cannot simultaneously maintain:
- A fixed exchange rate
- Free cross-border capital mobility
- An independent monetary policy
Core Mechanics: Bonds & Stocks
When you subscribe to a company’s bond, you lend money to that company.
When you buy a company’s stock, you own a small slice of the company.
Globally, the bond market is two times larger than the stock market.
A bond has three essential components that are fixed.
- Face Value. FV is what the investor gets at maturity.
- Coupon Rate. The rate at which the Bond is offered.
- Maturity Date. The future date when the Bond will be repaid.
The fourth component, the bond price, is not fixed.
Pricing, Yield, and the inverse relationship.
While the Face Value and Coupon Rate remain static, a bond’s Market Price and Yield fluctuate constantly in the secondary market.
Bond Price. An investor buying a bond with a face value of $1000, a 7% coupon rate, and a 10-year maturity receives $70 in interest each year and $1000 on the maturity date.
Imagine the interest rate rises to 8%.
Another investor buying the bond will get $80 every year in interest and $1000 on the maturity date.
If the first investor wants to sell his bond in the market, he will get less, say $930, because his bond is less attractive.
So, when the Interest Rate goes up, the Bond Price goes down, and when the Interest Rate goes down, the Bond Price goes up.
Bond Yield. An investor’s actual return is the yield.
An investor buying the above bond for $930 (owing to an increase in interest rates in the market) is still able to get $70 every year and $1000 on maturity. So, the investor’s actual return or yield is more than 7%.
Bond Yield goes up when the Bond Price goes down, and the bond yield goes down when the bond price goes up.
Impact on Equities and Debt Mutual Funds.
The bond market sets the price of money while the capital market sets the price of growth expectations.
When the price of money goes up, the price of growth goes down.
The ten-year Government Bond yield is regarded as the most risk-free return for an investor. Everything in finance is priced against it.
If bond yields rise (that is, when interest rates rise), Companies may suffer as their borrowing costs increase and profitability is likely to fall. In turn, their stock valuation is likely to fall; the high-yielding risk-free Government Bond will look more attractive to investors than risky stock market returns.
The thumb rule is: the higher the Bond Yield, the lower the Stock value.
If bond yields in the US go above 4.5% or in India above 7.5%, it is a caution time for stock investors in India. If Boind goes down below 4.5% and 7% in the US and India, stocks are likely to rise.
NAV of debt mutual funds rises when yields fall. That is when the bond price rises, or interest rates fall.
(If the market yield falls from 7% to 6%, New Bonds issued today will give only 6%. But the Fund already holds legacy bonds giving a yield of 7%, and hence the NAV of the fund shall rise.)
NAV of a debt MF goes down when yields rise. That is, when the bond market price falls, interest rates go up.
To summarize,
If interest rates increase, BP Decreases, bond yields increase, and Debt MF NAV Decreases
If interest rates decrease, BP Increases, the Bond Yield Decreases, and Debt MF NAV Increases
(This is the scenario in the secondary bond market, not in the primary market)
A company is valued based on its earnings and the current 10Y bond yield. Assume the 10Y yield is 6.5%.
The value of a company earning Rs.100 is valued @ 100/6.5% = Rs.1538
Assume the yield increased to 6.85%.
Then the value of the company is valued @ 100/1.85% = Rs.1460
So, with hardening of the bond rate, the company’s valuation has come down. This will be reflected in the stock price, and it may come down.
The Macro Drivers of Yield Movements
Bond prices and yields change daily based on broader macroeconomic expectations:
- Inflation Expectations: Higher inflation prompts central bank rate hikes, and Bond prices fall / Yields rise.
- Commodity Shock (Oil): Drives input inflation higher, and Yields rise.
- Fiscal Deficit: Excessive government borrowing increases bond issuance and the over supply drives the bond price down and it’s yield up.
- Geopolitical Crises / War: Flight-to-safety capital flows into sovereign bonds, leading to bond prices rising and yields falling
- Monetary Policy Shifts: External rate actions (e.g., US Federal Reserve hikes) drive foreign capital outflows, leading to emerging market bond price falls. If the RBI increases the repo rate, Bond prices fall, and yields go up.
Gilt Funds & Index Funds.
A gilt fund buys only Government of India Bonds. G-Secs. No company bonds. That means the investor lends money to the Government of India, so there is no default risk for the investor.
But there is high price risk.
If bond yields go up, that is, if interest rates go up, the Gilt fund NAV goes down sharply. Can fall by even 3 to 5 percent in a month.
If Bond yields go down (interest rates go down), the Gilt fund NAV goes up sharply. This is the golden time for gilt funds.
An index fund is nothing but a replica of an index. NIFTY 50 has the top 50 companies. Instead of buying winning company stocks, investors buy the entire market. Investors get the same return as the market’s gain or loss. Best for long-term investments of 7-plus years.
Monetary Policy: Repo Rate vs10Y yield
The RBI controls short-term liquidity via the Repo Rate (overnight lending), while the market determines the 10Y Government Security (G-Sec) yield based on long-term outlooks.
Transmission Mechanism: If the RBI hikes the Repo rate to curb inflation, borrowing across all maturities becomes costlier, pushing the 10Y yield upward. Conversely, Repo cuts lower borrowing costs and yield benchmarks. The gap between the repo and 10Y is called the yield curve.
Term Premium: In normal conditions, the 10Y yield trades above the Repo rate in India. An inverted yield curve (where long-term yields fall below short-term policy rates) typically signals an impending economic slowdown or sharp expectations of monetary easing.
How the Repo controls 10Y
Direction is always the same: if Repo is up, 10Y is also up, and if Repo is down, 10Y is also down. But Repo and 10Y do not have a one-to-one relationship, because 10Y, being long-term, also considers other factors like expected future inflation, Government borrowing plan, fiscal deficit, U S rates, Market mood, etc. Depending on these factors, however, the repo and 10Y can rarely move in opposite directions as well.
If the 10Y yield is much higher than the repo, the market will expect Inflation to remain high for a long. As the 10Y yield is falling towards the repo, the market will expect interest rates to fall soon.
When a new bond with a higher coupon is issued, the price of old bonds falls. Old bonds’ market yields rise to match the new bond yield.
When a new bond with a lower coupon is issued, the price of the old bond rises. The old bond’s market yield falls to match the new bond yield.
RBI uses this to control money.
Repo Rate, Fiscal Deficit, Inflation, Exchange Rate, and Gold Price have a strong interplay on the monetary framework at the macro level.
High Fiscal Deficit and high inflation, high commodity prices, and capital flight can weaken the exchange rate of the Rupee. This will force the RBI to increase the repo rate, which in turn makes bond yields go up and helps control inflation. It stops further weakening of Rupee by attracting dollars and makes the Rupee eventually stronger.
The weakening of the exchange rate will result in an increase in the cost of imports of Oil and gold, resulting in inflation going up. This will cause the fiscal deficit to worsen as the government has to provide for subsidies. As the fiscal deficit and repo rate are going up, bond yields will go up sharply, and the gold price in India will increase.
Impossible Trinity by Mundell-Fleming.
This theory states that a country cannot achieve the following three goals concurrently. A Country can achieve only any two of these goals
- Fixed / Stable Exchange Rate.
- Free Flow of Dollars, cross-border
- Independent monetary policy.
India has opted for Free Flow of Dollars and an independent monetary policy at the expense of a fixed exchange rate. The rupee is not fixed. The rupee has to be flexible.
After the recent Dollar inflow by way of FCNR deposits, the result is that India is sitting on huge liquidity of Rs.11 lakh crore. It will be interesting to see how the RBI manages this huge liquidity.
RBI cannot reduce the REPO because it will further reduce the already thin difference between Repo and Fed rates. That will make foreigners leave in a big way; the rupee will crash, and oil inflation will go up. A similar effect could be the result if the US increase FED Rate.
Passing Note. The rupee was defended from a sharp fall and seems to be gaining after the recent inflow of FCNR deposits with an intent to strengthen the Rupee, even at the expense of huge SWAP costs. The Purpose seems achieved but created a huge liquidity problem for the RBI to manage. It is interesting to watch how the long-term scenario will unfold.
Author: Jarard Thomas
Date: 09.09.26.
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