Indonesia’s central bank made a surprising move this week by cutting its key policy rate by 25 basis points to 5.75%, defying the expectations of all 38 economists surveyed by Bloomberg who had predicted no change. The decision, which came amid a period of heightened market uncertainty, has raised concerns about the potential risks for the country’s financial stability, especially with the looming policy changes from the US.
Rajeev De Mello, a global macro portfolio manager at Gama Asset Management, described the rate cut as a “risky move” that increases financial risk for Indonesia. He further commented, “With the imminent policy uncertainty emanating from the US, it is really not the time for emerging market central bankers to ease monetary policy.”
Government Bond Yields React to the Move
The rate cut follows a prolonged selloff in Indonesia’s government bonds, with the 10-year bond yield rising by over 50 basis points since the US election on November 6 — the largest such increase in emerging Asia. Despite the rate cut offering some near-term relief for bond yields, investors now face a more uncertain outlook for the bond market. The 10-year bond yield, which had risen to 7.32% before the decision, dropped slightly to around 7.27% after the cut.
However, many investors are now reassessing their expectations for Bank Indonesia. The central bank has a history of making unexpected moves, which makes forecasting its next steps particularly challenging. While the cut may ease short-term pressure on bond yields, it raises questions about the long-term stability of Indonesia’s bond market.
Rupiah Pressure and Currency-Interest Rate Dynamics
A critical concern is the impact of the rate cut on the rupiah, Indonesia’s currency, which has been under pressure in recent months. Over the past year, the rupiah has depreciated by 4.5% against the US dollar. Despite the currency’s struggles, Bank Indonesia’s Governor Perry Warjiyo emphasized that the central bank’s focus is now on balancing stability and growth. He stated, “We have changed our stance, which is to pro-stability and growth,” and reiterated the central bank’s commitment to adjusting interest rates according to both global and domestic economic dynamics.
One key factor contributing to uncertainty is the inverse correlation between the rupiah and bond yields. As of now, the 90-day correlation between the rupiah and the Bloomberg Indonesia local-currency bond index stands at -0.58, meaning the two have been moving in opposing directions. This negative correlation is the strongest among emerging markets in Asia, signaling that any movement in the rupiah could potentially have a significant impact on bond yields.
Bond Market Outlook: Pressures Persist
Although the rate cut provided some short-term relief for bond yields, the outlook for Indonesia’s bond market remains uncertain. Experts warn that the 10-year yield could rise towards 7.75%-8% if external factors, such as escalating US-China trade tensions, continue to add pressure. De Mello also pointed out that while the rate cut may provide temporary support, the broader risks to Indonesia’s financial markets remain significant.
Increased Bond Supply and Weaker Demand
A key concern for Indonesia’s bond market is the potential oversupply of bonds in the coming months. On January 7, the country’s conventional bills and bond auction attracted cumulative bids totaling 32 trillion rupiah ($2 billion), with 26 trillion rupiah in bonds sold — a bid-to-cover ratio of just 1.21 times. This is the lowest bid-to-cover ratio in at least five years, indicating weaker demand for Indonesian bonds.
Winson Phoon, head of fixed-income research at Maybank Securities, noted that the country’s Debt Management Office (DMO) seems keen on front-loading as much bond issuance as possible in the first quarter to build buffers against potential funding challenges. This includes preparing for the early Ramadan season starting in late February, which could increase demand for funding.
Foreign Fund Outflows and External Risks
Investor sentiment towards Indonesian bonds has been further soured by foreign fund outflows. On January 9, global funds pulled $152 million from Indonesia’s bond market, marking the largest single-day outflow in two months. This outflow was triggered by stronger-than-expected US employment data, which heightened expectations that the Federal Reserve may slow its rate cuts. This shift in US monetary policy expectations has added further volatility to global bond markets, particularly in emerging markets like Indonesia.
Bank Indonesia is planning to purchase around 150 trillion rupiah of bonds in the secondary market this year, more than the central bank’s pandemic-era bond holdings, which are set to mature in 2025. This is expected to help provide some stability in the bond market, but investor confidence remains fragile, particularly as the global economic landscape becomes increasingly uncertain.
Conclusion
Indonesia’s unexpected rate cut has injected uncertainty into the bond market and created new challenges for investors. While the move may provide short-term relief for government bond yields, questions about the central bank’s policy direction and the rupiah’s performance remain. With mounting external risks and increasing bond supply, the outlook for Indonesia’s financial markets remains unpredictable, and investors will need to closely monitor developments in the coming months.
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