Indian bond markets have being seeing volatility in yields since May 2013 when the news of imminent tapering of Quantitative Easing by the U.S Federal Reserve came to the fore. The yield volatility was largely a consequence of depreciation in the value of Rupee due to Fed tapering concerns.
However, a year after, there is a marked turnaround in bond yield movements. The major factor is favourable base and decline in price of crude which has fallen 44% since June 2014. Another reason is the slow rise in Minimum Support prices (MSPs) of food grains which increased only 4% this year. Future outlook depends on crude movements, possibility of interest rate hikes in the U.S, trends in inflation etc.
Inflationary expectations
Actual and expected levels of inflation will influence key rates. Based on the 30th Round of professional Forecasters Survey, CPI and WPI inflation are expected to evolve as follows:
Though actual and expected inflation rates may differ and crude price decline was a factor not foreseen at the time of this survey, the huge fall in CPI has come due to base effect. This is going to wane from January 2015 onwards. Then the only factor which gives some respite is the low pace of rise in MSPs and lower prices of commodities and food grains in the global markets which depresses prices at home also. Though crude prices have declined, we have not yet seen any immediate percolation down to the end consumer. On the contrary, sustained low oil prices are bad for Russia, Nigeria, Venezula etc which may altogether stop oil production due to unviability, ultimately increasing oil prices. Hence, the risk is on the upside for inflation trends (though a hike will not happen until March 2015)
Liquidity scenario
Liquidity scenario is comfortable since credit growth has been falling below deposit growth. The recent RBI data shows credit growth on a y-o-y basis At 10.6%, while growth in deposits are at 10.9%. However, the low credit growth is due to sluggish economy and investment climate not yet picking up further.
However, due to declining CAD and strengthening Dollar due to improving macros in the US, RBI may have to sell more Dollars to stem INR depreciation. However, this may not significantly influence bond yields.
Dollar-Rupee exchange rate
Improving macros in the US has led to speculation that the prospects of a hike in interest rates by the Fed look more imminent than ever. Growth is now consistently above 2.5% for the past three quarters in the U.S. Recent Nonfarm payrolls data for November 2014 shows a rise in employment by 321,000 (p) much higher than 237,000 for the previous month. But there is widespread risk aversion globally due to crisis in oil rich countries and low factory output from China, leading to pullout of funds by FIIs during the past sessions. Rise in volatility as evidenced by the Volatility index (VIX) rising 16% to 16.8, profit booking and year end season also leads to pullout by FIIs.
However, data released by the U.S Congressional Budget Office shows budget deficit for November declined to $ 56.5 billion compared to $ 135 bn last year. This may lead to some decline in US Treasury yields and a downward pressure on inflation. This was made possible due to a 4.9% y/y increase in receipts attributable to receipts withheld in 2013 in view of fiscal cliff.
The U.S Fed is not willing to commit a specific time frame for a hike and as usual states that everything is data dependent. Fed rate is a major factor impacting domestic bond yields and viewed from this perspective, now a huge upside to yields are limited.
Fiscal deficit and Current Account Deficit
Fiscal deficit has already reached 99% of the year end target during April-November of the current fiscal. This is attributable to the slow rise in indirect tax receipts to the tune of 5.3% during this period as against the target of 19% for the full year. The rise in deficit is despite huge transfer of funds to the extent of Rs.52,000 Cr from RBI. Moreover, disinvestment’s have not met with any major success and if they are bunched up during the last quarter, realizations might be adversely impacted due to price declines. Regarding spectrum auctions, the operators are required to pay only a third of the money upfront. Moreover, GST Bill is stuck due to lack of agreement as to whether states need to be compensated for 3 years of revenue loss or of five years. Even a 3 year compensation will lead to an outgo of Rs 11,000 cr .Next fiscal will see the burden of the implementation of Food Security Bill as well. So borrowing programme is set to rise which gives an upside to yields.
It is also pertinent to remember that despite WPI inflation falling tom zero, the 10 yr benchmark did not slide much. Also Russia and Brazil hiked their rates. Moreover, INR has a weakening bias next year due to Dollar strengthening and RBI undertaking purchase of US Dollars to improve import cover. This gives an upward bias to inflation. Rising non-oil-non-gold imports is yet another factor giving Rupee a weakening bias.
On balance, while fiscal deficit, pullout of funds due to risk aversion and inflation rising from January 2015 poses upside risks to bond yields, substantially lower crude prices, is a huge offset. Moreover, global risk aversion may reverse since India is still the best performer among emerging markets.
The possible widening of stimulus by ECB and BoJ will also add to capital flows.To sum up, we can conclude that given strong macros, UST yields are likely to rise from and the 10 Yr Government of India benchmark is likely to hover around 8.00/8.10 till March 2015.
