Even as the RBI gave in to market expectations and lowered its key policy repo rate in its August policy, bond markets have had little to cheer. The yield on the 10-year G-Sec has inched up by 10 basis points to 6.5 per cent levels over the past month.

Despite cutting its policy rate, the RBI retained its neutral stance in August. The recent July CPI inflation witnessing a slight uptick, has also kept bond markets on tenterhooks. With no-near term trigger in sight for a rate cut, bond yields have remained sticky. But given that the real rate—yield on one-year Treasury bill less inflation-- still remains high, further rate cuts and hence fall in yields cannot be ruled out altogether.

No near-term respite

Even though the yield on the 10-year G-Sec has fallen notably over the past year, there have been bouts of volatility. While the RBI’s rate cuts last year and the excess liquidity in the system post-demonetisation, led to a sharp fall in G-sec yield by the end of 2016 (to 6.2 per cent levels), the RBI shifting its policy stance from accommodative to neutral in the February policy, saw bond yields inching up.

With the market factoring in zero possibility of rate cuts, yield on G-Sec went up to 6.8-6.9 per cent levels between March and April, before heading south once again on favourable inflation numbers.

Now, with CPI inflation moving up to 2.36 per cent in July from 1.46 per cent in June, and expected to firm up in the coming months, markets are factoring in limited rate cuts.

The demand supply situation also remains adverse in the short term. Foreign portfolio investors (FPIs) have been pouring money into our debt markets. Currently, as per the latest debt utilisation status data available in NSDL, FPIs have exhausted 98.3 per cent of their limits in central government securities. This offers them little headroom to continue their aggressive buying. From around Rs 25,600 crore in the month of June, their net investments in debt has come down to about Rs 13,600 crore as of August (upto 29 Aug)-- albeit a healthy inflow.

Banks have been lapping up government bonds due to lack of lending opportunity. But given that they are already sitting on a large portfolio of government bonds—deploying 7-10 percentage points more than that mandated under SLR requirement-demand from hereon could be limited. Private sector banks and PSU Banks have net sold government bonds to the tune of about Rs 34,000 crore and 57,900 crore respectively between April and July.

On the supply side, excess liquidity has nudged the RBI to conduct open market sales of Rs 10,000 crore each of four occasions. Hence given the demand supply situation in the near term, bond yield may remain sticky around current levels.

Medium term view

While near-term triggers look elusive, given the high real rate and weak growth, some believe that rates could fall over the medium term.

“The yield on one-year treasury bill is around 6.2 per cent. If we assume CPI inflation of 4 per cent on a durable basis, then the real rate is a high 2.25 per cent. While rate cuts may not necessarily aid growth one cannot have excessively high real rate in a weak growth environment,” says Suyash Choudhary, Head of fixed income at IDFC Mutual Fund.

The RBI, last year had indicated a real interest rate target of 125 basis points.

“Bond valuations are also not particularly rich. This indicates more scope for bond prices to rally over the medium term, rather than deep sell-offs in bonds,” adds Suyash.

However, there are some risks to inflation that may need watching. CPI inflation is likely to head north in the second half of this fiscal on the back of HRA increase and base effect trickling in. Post GST, higher taxes on clothing, health, medicines, education, housing and mobile services will likely exert upside pressure on inflation. Also, housing, which has a 10 per cent weight in CPI, has more or less remained sticky. While inflation is likely to remain within the RBI’s target of 4 per cent by the end of the year, given that it has been rigid on its target (unwilling to use the 2 per cent leeway) it may continue to remain tight-fisted on future rate cuts.

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