The Indian Rupee (INR) is trading at eleven months highs of around Rs 58.75 to the USD while ten year benchmark government bond yields are trading at close to four months highs of 8.71% on the day of 2014 general elections results showing an overwhelming majority for the Modi led BJP.
The INR has rallied by close to 15% from lows seen in August 2013 and is up by over 2% over the last one week. Ten year benchmark bond, the 8.83% 2023 is trading 140bps higher year on year, though it is down by 40bps since the beginning of April 2014.
What does the new government have in store for the INR and bond yields?
The strong performance of the Sensex and Nifty on the back of Modi led BJP forming the government at the centre is reflecting in the strength of the INR. Sensex and Nifty are up over 10% over the last one week and are trading at record high levels. Strong equity performance gives rise to expectations of strong FII flows. FII equity purchases have been muted with investment of around USD 1.5 billion in April and May. Markets may expect FIIs to increase their investments post the election verdict.
The more important factor for the INR is the government policies on deficits and inflation. The new government showing commitment to lowering inflation expectations and lowering the fiscal deficit and keeping current account deficit at lower levels is highly positive for the INR.
Global factors of risk aversion, Fed raising rates and relative strengths of economies will be crucial for the INR. At this point of time, risk aversion is low as seen by rally in PIIGS bond yields and high interest rate differentials are helping the INR to strengthen.
The INR is likely to stay at higher levels to the USD in the coming days given expectations of a good budget from the new government and continued global investor appetite for higher yields.
Government bond markets will not really pull down bond yields unless there is a clear expectation that the budget will focus on keeping borrowing in check. The market will also watch for any signs of friction between the new government and the RBI as this could raise expectations of higher inflation going forward. Monsoons too will have a part to play on bond yields as the EL Nino factor could impact inflation.
The environment for bonds is much better now with the INR strengthening, FIIs looking at higher yields offered on domestic bonds and a stable government at the centre. Bond yields are likely to stay steady with a tendency to fall as the government bond supply reduces in June by almost 50% from May levels.