By: Punam Sharma
Even as the new government completes a credible month in office, the bond market has witnessed significant volatility with yields back-tracking almost 20 bps over the past 2 weeks. While it is true that some retracement after a 50 bps rally is only to be expected, there are 3 concrete reasons that are behind the market’s near term worry. These are:
1. Recent tensions in Iraq and their impact on crude oil prices: Brent prices are up some 5% over the past few days as fighting has flared up in Northern Iraq. While most oil facilities are situated in the southern regions, there are legitimate worries with respect to the trajectory of oil prices should violence escalate.
2. Prospects of monsoon under-performance: India’s Met department has a sub-par monsoon forecast and global weather forecasters are predicting a majority chance for an El Nino phenomenon this year; although recent oceanic and atmospheric conditions seem to have swung back into neutral territory. Furthermore, monsoon performance so far has been severely disappointing with rains tracking 38% below their long term average over June. Depending upon severity of the rain deficiency, market fears that primary articles’ prices may spike again in the months ahead.
3. Near term demand versus supply for government bonds: FIIs have bought approximately INR 30,000 crores of India’s government bonds post announcement of election results. This had significantly improved the demand versus supply scenario of bonds. However, the regulatory limits given to FIIs for government bond investments have now been almost completely utilized. Owing to this, and pending further relaxations to FII limits, demand versus supply for bonds is no longer looking as robust as it was before; at least in the near term.
All these 3 reasons are legitimate and, admittedly, in their worst manifestation can cause substantial volatility in markets. However, what is also true that almost all can be characterized either as ‘event based’ or having a limited period impact. On the other hand, there is another evolving development to keep track of; one that if continued can provide enduring improvements to our macro-economic situation with long term positive consequences for bond market returns: the performance of the new government in speeding along India’s adjustment process. While it is still early days, the government seems to have well and truly swung into action. Some of the key areas covered so far by the new government are as follows:
1. Host of steps on inflation including advising states to delist fruits and vegetables from APMC, increasing supply of potato and onions at retail outlets in Delhi, releasing rice stock into open market, and provision of credit to states for importing pulses.
2. A substantial hike in passenger fares and freight charges to improve railway finances. Media reports suggest that some staggered increases in kerosene and LPG prices may also be unveiled in the Budget in order to cap fuel subsidies.
3. Weighted average minimum support prices (MSPs) for kharif crops increased by only 2%. This was 6% in FY 14 and 24% in FY13. This is medium term positive for inflation control as higher MSPs used to put a higher floor to food prices.
4. Media reports suggest that disinvestment targets for the current year may be scaled up significantly thereby easing the pressure on fiscal deficit.
In our view, in absence of complementary government response, the burden of ensuring India’s macro-economic adjustment would have fallen squarely on the RBI. However, with a responsive government in place the RBI can be in wait and watch mode and let the government drive the adjustment process (please refer “The Great Adjustment Continues: A Bond Market Update”, dated 27th May). This is precisely what seems to be happening so far. The government has kicked into action whereas RBI’s latest commentary in the last policy review was decidedly a shade dovish on the margin. Ongoing developments have provided the trigger, and the recent rise in yields the opportunity, for us to switch a significant part of our 5 – 9 year exposure to the 13 – 16 year segment in our bond and gilt funds.
We are aware that should one or more of the bearish triggers mentioned above intensify, there may be further volatility in yields. However, we also recognize that as the ‘Great Adjustment’ progresses, it is bringing us closer to a phase of secular bullishness. It is to be noted that this assessment is a direct result of the election outcome and the policy intent that has been shown by the new government, which will likely allow RBI to take a back-seat. Thus it is quite different from the ‘perma-bull’ views that were calling for falling interest rates much before either the election outcome or the new government’s policy framework were known.
Finally, investors should keep a ‘portfolio framework’ in mind and avoid over-allocating to one profile of funds based on near term triggers. As explained above, in our view the medium term outlook is decidedly much more positive than it has ever been over the past 4 years. If investors agree with this prognosis, then their long term portfolio allocations should reflect this belief. At the same time, there are enough near term factors that can continue to cause interim volatility. A portfolio approach that matches risk appetite and investment horizon to product selection and avoids over-allocation to one profile of funds will help weather such volatility.
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