By: Punam Sharma
Bond markets have struggled to find their feet for most of the last 3 months. A series of triggers have contributed towards this lack of risk appetite. The global environment, most chiefly the recent sharp rise in oil prices, has definitely contributed. However, as we had detailed in a recent note (please refer “The Three Wishes Of The Bond Market”, dated 8th November), there have been three domestic obstacles as well that have contributed to the recent sharp rise in bond yields. These are: RBI’s commentary, OMO bond sales, and fiscal uncertainties. From a probability standpoint, we had opined that there is very little chance that RBI’s commentary turns. We had ascribed an even likelihood of OMOs stopping soon given the crowding out they were causing and RBI’s own assessment that excess liquidity in the current environment is largely non inflationary. Finally, we had assessed that although prospects of fiscal slippage are real, the extent of it is perhaps better defined now given the finance minister’s own expressed intent of adhering to the glide-path.
One Wish Granted
As things have turned out, and to the market’s immense relief, the RBI has indeed chosen to cancel its latest scheduled OMO. This has been generally interpreted as a yield signal from the RBI and has led to a large relief rally in bonds. Our view (hope) on this is more general and in line with our previous thinking: that it may have finally come to RBI’s realization that the OMOs are an instrumental reason for the crowding out of the market and hence they have chosen to take a bit of a backseat for the meanwhile. The visible liquidity surplus at the headline level is also now well contained although had this been the primary reason, then RBI would have not announced the latest OMO rather than cancel it post a substantial market sell-off. If indeed OMOs are off the table for now, then this takes away a large avenue of excess supply for bonds and, ceteris paribus, should arrest the free fall that bond prices were in and even shift the trading range on yields a little lower. Equally importantly, from our portfolio standpoint, it removes supply from the 4 – 9 year segment of government bonds. As discussed before, we are the most overweight here and valuations between 80 – 125 bps over repo in this segment indeed look quite attractive.
The other recent development, that failed to generate any sustainable excitement from bonds, was India’s sovereign debt upgrade by a notch by Moody’s. Admittedly, this did not alleviate any of the current pains of the bond market, given that foreign institutional investors are almost full limit on local bonds. However, there could be some implication here for the tone of RBI policy. It can be argued that there is little reason for incremental hawkishness from RBI given this development. If the central bank were to interpret its mandate in the broadest sense, it is to ensure financial stability. The CPI target is a tool to ensure this end objective of financial stability. Now, to be clear, there is no case to made that the RBI ‘go easy’ on this mandate. However the element of additional hawkishness that had crept in recently, owing possibly to risks to financial stability that the central bank saw in context of potential developed market (DM) tightening, can potentially be dialed back. Of course, this is so long as the RBI broadly believes its own medium term CPI target. However, from a portfolio strategy standpoint, this is not something we will bank upon. To reiterate, the focus remains on finding absolute value under a view that the repo rate remains unchanged for an extended period of time.
There is a tendency to double or triple discount the same news in the market. Thus risks around fiscal and oil seem to have been flagged continually over the past 35 bps of sell off. Two points need attention here: One, market yields are at these levels because of some headwinds to the market. So it is not enough to keep lamenting these headwinds at every level of the market. Rather, one has to be clear on what the issues are. As discussed above, the assumption clearly already is that there are no further rate cuts. Bond valuations, at least on parts of the curve, are sufficiently attractive for the market not to need a rate cut. Rather the question is whether adverse macro developments seen so far can merit a rate hike. We believe this is clearly not the case given RBI’s own medium term CPI forecasts and the stage of the domestic economic and credit cycle. Two, one needs to be clear on the ramifications of the fiscal concerns that are doing the rounds: A slippage may push back prospects of a rate cut, but we aren’t assuming any cuts to begin with anyway. However, it may also lead to higher bond supply. If this is substantial then it will indeed be a cause for worry. However, if it is only worth a couple of auctions extra then market may tend to take it broadly in its stride. As a case in point, the market has absorbed INR 90,000 crores of OMO bond sales from RBI. This is equivalent to what the government would have borrowed extra had there been a 0.5% expansion in fiscal deficit fully financed via market borrowings. Thus the fact that OMOs are likely to stall from here should at least partly serve to offset any concerns around fiscal slippage.
To reiterate from a portfolio strategy standpoint, the environment is more of value picking parts of the curve under an assumption that the repo rate doesn’t change for a longish time; rather than one of sustained market momentum. However, there seems to be little here that suggests the kind of market breakdown that we briefly saw over the past few days. There is also enough here to keep investors interested, especially given the levels on alternatives including bank deposits and tax free bonds.
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