Bond markets will tussle between rate cut expectations and higher borrowing expectations leading to range bound bond yields until there is a clear signal on either one or both of the factors.
GDP growth for the first quarter of 2012-13 came in at 5.5% against a growth rate of 8% seen in the first quarter of 2011-12. The fall in GDP growth would normally be positive for the bond market as rate cut expectations build up in bond yields. However the fall in GDP growth had a negative effect on bond yields with the ten year benchmark bond the 8.15% 2022 bond seeing yields rise by 5bps post GDP number release. Bond markets are worried on RBI maintaining policy rates status quo in its mid quarter policy review in mid September and are also worried on fiscal deficit numbers rising on falling GDP growth.
The fall in GDP growth is positive and negative for bond markets. The market will take direction from two factors a) Rate cuts (or no rate cuts) by the RBI and b) Absolute government borrowing number for second half of 2012-13. The fact that GDP growth came in at 5.5% for the first quarter of 2012-13 will have to push up growth numbers for the next three quarters if both government and RBI estimates of 6.7% and 6.5% respectively for the full year 2012-13 is to be met. GDP growth should clock close to 7% for full year growth rate of 6.5%.
The current state of the economy with gross fixed capital formation at 29.9% for the first quarter of 2012-13 is not conducive for rising GDP growth. Gross fixed capital formation, which indicates the investment rate in the country, is the lowest for the first quarter since 2005-06 (Source: DNA Money 1st September 2012) and is down from peaks of 33.8% seen in 2008-09. The government finances do not permit it to pump prime the economy while the private sector access to capital, both debt and equity capital, is low given the weak state of capital markets. Government’s fiscal deficit is expected to be higher than budgeted levels of 5.1% of GDP given economic slowdown and equity and bond markets have still to come out of a slump.
RBI has to cut rates and infuse liquidity into the system if GDP is to grow at 7% levels for the next few quarters. The second quarter of 2012-13 is almost coming to a close and with below normal monsoons for this year, it is highly unlikely that GDP growth for the second quarter of this fiscal will come in at 7% levels. The question is when will the RBI cut rates? RBI speak suggest that the central bank is still ambivalent on rate cuts citing suppressed inflation in the economy through non pass through of commodity prices. However if RBI refrains from reducing rates in its September policy review, it will have to lower GDP growth forecast to 6% and below, which by itself is an admission of economic growth being hurt by many factors including high interest rates.
On the fiscal deficit side, a lower GDP growth will help increase the fiscal deficit. The government has budgeted for a fiscal deficit of 5.1% of GDP for 2012-13 and has targeted a borrowing of Rs 479,000 crores to finance its fiscal deficit (93% of total deficit). The government’s budget forecast for GDP growth was 7.6% and it has since revised the forecast to 6.7%. The slower GDP growth (even if revised forecasts are achieved and this looks difficult at present) will bring down absolute GDP levels leading to fiscal deficit trending higher. However what remains to be seen is will the absolute borrowing number of Rs 479,000 crores go up? The government may not want to increase its borrowing given the bond market’s aversion to higher supply but markets will wait for the release of the borrowing calendar for the second half of 2012-13 before taking any directional bets.
Government bond auctions
The government auctioned Rs 15,000 crores of bonds last week. The bonds auctioned were the 8.19% 2020 bond for Rs 4000 crores, the 8.33% 2026 bond for Rs 7000 crores, the 8.28% 2032 bond for Rs 2000 crores and the 8.33% 2041 bond for Rs 2000 crores. The cut offs came in at 8.34%, 8.40%, 8.58% and 8.62% respectively. The government is scheduled to auction Rs 16,000 crores of bonds this week.