What started as a dismal year is turning out to be one of the best phases of the Indian bond market since the global financial crisis of 2008. Compared to an average annual return of 6 per cent since 2009, the Indian bond market is on track to deliver a 16 per cent gain in 2016 (as per the total return index for sovereign bonds which includes both coupon accrued and capital gains). The decline in 10-year benchmark yield by around 135 basis points (bps) so far in 2016 stands out among emerging and developed markets.

Triggers in 2016 This year, the first trigger towards bullish pricing of Indian bonds emerged in April. That’s when the RBI changed its stance on liquidity management, announcing that banking sector liquidity will be gradually moved from a deficit to neutral territory. The change in stance led to more OMO (open market operation) purchases from the RBI and subsequent liquidity infusion of around ₹1.1 trillion.

An additional element of exuberance developed in the third quarter of 2016. The exit of Raghuram Rajan as RBI governor boosted expectations of a rate cut, leading to further decline in domestic bond yields.

According to market expectations, even as the new Monetary Policy Committee slashed the repo rate by 25 bps in October, its commentary was somewhat mixed. Therefore, amidst growing uncertainty in the global markets (Brexit and US elections), the rally in Indian bonds eased off after the rate cut in October. Until, of course, demonetisation happened. In November, the government’s demonetisation move once again lit up the mood in the bond market. As domestic credit growth remained sluggish, a sharp rise in bank deposits led to a bond-buying spree. As a result, the benchmark bond yield declined by 60 bps within 15 days of the demonetisation drive.

Is there more juice left? The dynamics seem to be changing now. For one, the RBI has been sucking out excess liquidity from the markets. Two, instead of fretting on growth, the RBI seems to be worried about inflationary risks.

In the December monetary policy review, the RBI unexpectedly left policy rates unchanged saying that growth pain on account of demonetisation is ‘transitory’ and that there is enough demand in the system to make it worry over inflation. Lastly, the hawkish stance of the US Fed is also leading to re-pricing of bonds globally.

While a 25 bps rate hike (announced last week by the Fed) was already factored in, what has proven to be more pertinent from investors’ perspective is a steeper path for the Fed funds rate in 2017. In reaction to such negative factors, the benchmark yield in India has gone up by around 40 bps from the post-demonetisation low of 6.11 per cent. Even as the hawkish stance of both the RBI and the Fed could weigh on market sentiment in the near term, I believe that at current levels, Indian bonds are a good buy.

Why buy The downward revision in the growth forecast by the RBI in its latest monetary policy review was rather modest in my view. With a further slowdown in economic growth, which appears more likely now, the RBI could revise its forecast lower in the first quarter of 2017. In such a scenario, the RBI may cut the policy rate in order to speed up the recovery process, even if the slowdown is ‘transitory’. In the interim, even as excess liquidity is sucked out through the Market Stabilisation Scheme (MSS) window, build-up of a deficit-like situation is unlikely. The MSS absorption is temporary and despite the cash withdrawals, there is a certain level of durable deposits that the banking sector is expected to garner on account of the demonetisation.

On the international front, the Fed’s aggressive tone is pinned on hopes of faster economic growth in the US, spurred by the incoming Trump administration’s plans to cut taxes and boost spending. While a lot is actually contingent upon how Trump’s policies shape up, economic growth is unlikely to pick up immediately.

Moreover, with several policy officials raising concern about high government debt, Trump may have to eventually balance his ambitions of greater fiscal stimulus with the risks of a ballooning fiscal deficit. Thus, a more hawkish outlook announced by the Fed at this point in time may not mean much, going forward. Even in December 2015, the Fed had projected four rate hikes for 2016 but only one actually happened.

With a possible repricing of the Trump-factor, along with growing expectations of a policy rate cut by the RBI, we could see another wave of buying in the Indian bond market early next year. This time however, the room to play might not be much. For one, India cannot afford to de-link its interest rate trajectory completely from the US. Two, the global commodity price outlook is far less benign and the room for the RBI to cut rates would not be much. At best, we could see the benchmark bond yield settling around 25 bps lower than the current levels.

The writer is Senior Economist, HDFC Bank

Related Topics
comment COMMENT NOW