Podcast 19th June 2015
The sharp rise in government bond yields and corporate bond yields over the last two months have unnerved bond/bond fund investors. Bond yields have risen by 30bps to 50bps across the curve despite a 25bps rate cut by RBI in its 2nd June 2015 policy review. Investors have been bullish on Indian bonds since last year, when a stable government, improving macro economic fundamentals and global liquidity flows brought down bond yields by over 100bps.
The question being asked now is whether the bond rally is over and will yields rise much further from hereon. The new ten year benchmark bond, the 7.72% 2025 bond is trading at yields of 7.80% as of 18th June, up 17bps from lows seen on 1st June 2015 but down 10bps from highs seen on 15th June.
The question on whether the bond rally is over is best answered by a set of three questions and answers. The reasons for rise in bond yields are covered extensively in our analysis “Is the bond market worried about a July 2013 repeat?”
Q1. Has CPI inflation bottomed out and will it only rise from hereon?
Ans1. CPI inflation printed at 5.01% for May 2015 while core CPI stripped of Food inflation was at 5.3%. RBI has indicated CPI will be at levels of 6% in January 2016. The drivers of inflation are not very strong on the domestic and global front.
On the domestic front, demand outlook is still weak. Exports fell 20% in May while imports too fell 8.4%. Rural demand is seen slowing down on expectations of below normal monsoons. Bank credit growth is below 10% levels. Corporate sales are not robust across sectors.
On the global front, outlook for commodity prices from oil to base metals is weak given weakening demand on the back of China growing at below trend levels of 7%. Commodity driven inflation is not on cards especially as the Fed
Is on course to hike rates this year keeping the USD strong.
Core CPI has been sticky at levels of around 5.2% over the last few months and with domestic and global drivers for inflation looking weak, CPI is unlikely to rise on a sustained basis. Food prices tend to be volatile but sorts itself out over a period of time.
Q2. Are government finances under threat leading to higher than budgeted fiscal deficit?
Ans2. High fiscal deficit is a leading cause for inflation in India. The government has budgeted for a fiscal deficit of 3.9% of GDP in this fiscal year going down to 3% of GDP over the next two years. The start to the year on indirect tax collection was positive with 39% growth in the first two months of this year. The economy is projected to grow at around 8% in this fiscal year from last year growth levels of 7.3% and this should pull up tax collections. Unless the government increases spending sharply from budgeted levels, it is likely to meet its deficit targets.
Q3. What about Fed rate hikes?
Ans3. Fed in its policy meet on the 16th and 17th of June stated that it will start hiking rates this year from record low levels of 0% to 0.25% but over the next eighteen months, the hike will be gradual and Fed rate can go up to 1.5%, which is still well below rates of 5% seen prior to financial crisis of 2008. Inflation expectations are low in the US and Fed sees no threat to inflation given moderate pace of expansion in the US economy. Fed rate hikes when it happens are unlikely to cause stress in financial markets given that it’s a process of normalization of policy. Fed rate hikes are unlikely to cause shift of capital flows leading to volatility in the INR as yield differential between US and Indian policy rates is high at 700bps.
Indian bonds are fundamentally better off than what they were a few years back and it’s too soon to give up on them. Watch out for risks but stay positive.
Attend our Knowledge Workshop on Managing Yield Curve and Credit Spread Risk on Fixed Income Portfolios on 17th of July 2015 at Sofitel BKC Mumbai. Please call Neelima at +919819770641 or log in to INRBONDS.com to register. Thank you for listening in.