17 Dec 2017 15:19 IST

What’s in store for bond markets in 2018?

With rate cuts out of the picture, bond yields are expected to hover in a narrow range

After a stellar run in 2016, bond markets put up a somewhat tepid show in 2017, which was surprising, given that the year began on a rather upbeat note. The only rate cut (by 25 basis point) by the RBI in August this year too failed to enthuse the bond markets. After the steep 1.2 percentage point fall in 2016, the yield on the 10-year G-Sec hardened in 2017, inching up by about 80 basis points.

Since July-August, bond yields have been creeping up. Ironically, even as the RBI gave in to market expectations and lowered its key policy repo rate in its August policy, bond markets have been on tenterhooks. Moody’s upgrade of India’s sovereign bond rating and the RBI cancelling open market operations or OMOs (bond sales) also did little to ease bond market worries.

What’s made the bond market jittery? Concerns over rising inflation on the back of uptick in global oil prices, tightening of global liquidity as global central banks look to move away from excessively easy money policies, worries over the India’s fiscal slippages — all these have pulled the plug on the bond rally for now.

After raking in hefty gains of 16-18 per cent in 2016, top long-term gilt funds delivered just 5-6 per cent gains in 2017. So, what’s in store for our bond markets in 2018?

Here’s a look at the key factors — inflation trends, fiscal policy, demand supply dynamics of government bonds and liquidity — to understand where we are headed.

Risk to inflation

Ever since the RBI put in place a monetary policy framework that focusses on inflation targeting, over two years back, policy actions have been driven by the movement in CPI inflation. In 2017, led by a sharp decline in food prices, CPI inflation fell to a low of 1.5-2 per cent between May and July.

But it was only in August that the RBI relented and cut its key policy repo rate by 25 basis points to 6 per cent. Since then the RBI has settled for a long pause.

As if taking the cue from the RBI’s growing concerns over inflation outlook, CPI inflation has been steadily creeping up in the past two to three months, thanks to the sharp increase in food prices. The RBI has been revising its CPI inflation target for the second half of the fiscal, from 3.5-4.5 per cent earlier to 4.2-4.6 per cent in the October policy, and to 4.3-4.7 per cent in the latest December policy.

Increasing crude prices and HRA increase under the Seventh Pay Commission, according to the RBI, can lead to upside risk to inflation forecasts.

Our view: The recent increase in CPI inflation, from 3.58 per cent in October to 4.88 per cent in November, has been led by increase in food prices — a sharp uptick in vegetable prices at that. Core CPI inflation (excluding food and fuel) also remains elevated at 4.9 per cent.

While prices of vegetables may see some seasonal moderation in the coming months, rising core inflation on the back of increasing crude prices and HRA increase under the Seventh Pay Commission can play spoilsport. Moreover, given that it was between November 2016 and January 2017 that vegetable prices plummeted the most, base effects could lead to overall CPI inflation overshooting the RBI’s forecast.

Given that the RBI, has been rigid on its 4 per cent medium-term target (unwilling to use the 2 per cent leeway), rate cuts seem out of the picture for now.

Fiscal worries

The Finance Minister, in the 2017-18 Budget, choosing to rein in fiscal deficit target at 3.2 per cent of GDP had no doubt pleased bond markets.

But several risks to the Centre’s fiscal deficit target have emerged through the year. The Central government’s spending reached 60 per cent of the target YTD (April to October), while revenue receipts touched a lower 48 per cent of the target during the same period. Consequently, fiscal deficit has reached 96 per cent of the target so far. Even after including the entire proceeds through disinvestment, the Centre’s fiscal deficit is over 90 per cent of the target.

Several States announcing farm debt waivers also has ramifications for the fiscal burden of States over the medium term. In the recent years, States’ market borrowings are increasingly becoming comparable to the Central government borrowing programme. Share of states’ net borrowings in the combined (state and Centre) borrowings has risen from 24 per cent in 2012-13 to 44 per cent in 2016-17.

Our view: The Centre had planned a gross market borrowing of ₹5.8 lakh crore for FY18, of which ₹3.72 lakh crore has been raised between April and September 2017. According to the calendar released by the RBI, the remaining ₹2.08 lakh crore is to be raised between October 2016 and March 2017.

While the Centre has indicated its intention of sticking to its fiscal deficit target, it has also not ruled out reviewing its borrowing target in the fourth quarter of FY18. Between January and February 2018, the borrowing calendar has set government bond issuances at a lower ₹5,000 crore each across five weekly auctions, as against ₹15,000 crore until December 2017.

However compelling the reasons, bond markets clearly will not like the Centre straying from its fiscal deficit target, which is a very likely possibility. Rising state deficit and debts are also now a worry as they can have an inflationary impact.

In FY18 so far, States’ gross borrowings stand at ₹2.43 lakh crore (as of December 1). The pace of borrowings generally increases in the fourth quarter as States tend to make up for any shortfall from other sources.

Fiscal slippages both on the Centre and state front remain a key overhang over bond markets.

Demand dynamics

One of the key factors at play in the bond markets has been the ample appetite for government bonds, both from overseas as well as domestic investors in 2017. Foreign investors, so far (as on December 11) have pumped in ₹1.48 lakh crore of money into the debt market in 2017.

On the domestic front, banks, particularly PSU banks, flush with liquidity post demonetisation, have been lapping up government bonds. PSU banks have been net buyers of government bonds to the tune of about ₹31,400 crore between January and November. Mutual funds, which have seen investors pour money into debt funds, have been net buyers to the tune of ₹1.38 lakh crore.

Going by data put out by NSDL (National Securities Depository), overseas investors continue to show ample appetite for government bonds. As on December 11, FPIs have nearly utilised their limits (99.2 per cent) to invest in government securities.

Higher real interest rate and stable currency continue to draw FPIs into the Indian debt market. The 10-year government bonds in India today offer a yield of about 7.2 per cent; in the US 10-year gilt offers 2.3 per cent. The real return on Indian bonds is about 3 per cent currently (based on medium term inflation of 4 per cent). The rupee has been one of the better performing Asian currencies, gaining about 4.6 per cent this year against the US dollar.

Our view: Unless the Fed increases its rates very sharply, the rate differential between India and the US is likely to hold out. The rupee too is likely to remain stable in 2018.

While there could be some tightening of global liquidity, a sharp liquidity squeeze is unlikely. That said, the biggest worry for India is the fate of the US tax bill that allows companies to bring profits back to the US at reduced tax rates. Such an exodus of funds can send ripples of shock through our bond markets.

On the domestic front, banks have been flush with funds post demonetisation. Banks can borrow money for the short term from the RBI under the liquidity adjustment facility (LAF). Alternatively, banks can lend their excess funds to the RBI through reverse repo (absorption of liquidity).

Net average absorption of liquidity under LAF has declined from ₹2.22 lakh crore in September to ₹1.4 lakh crore in October and further to ₹71,800 crore in November. Marginal surplus liquidity could continue into the last quarter of FY18, and it should tend to neutrality by first half of FY19. The RBI assuring durable liquidity by forex intervention, repo operations and OMOs (buying of government bonds) if need be, lends some comfort to bond markets.

The RBI has been shoring up its forex reserves, making the most of the rupee’s rally in 2018. Armed with $400.7 billion of forex reserves (as of November 24), it can sell dollars to stabilise the currency.

As of October, the RBI also had an outstanding forward position of around $31.3 billion. Taking partial delivery of the forward contracts will also inject money into the system, keeping liquidity in a marginally surplus zone in the near term.

Demand supply dynamics and liquidity conditions are unlikely to turn too unfavourable in 2018. Large flows from Indian markets into the US, can however throw our bond markets out of kilter.

Bottom line

While higher real rate, stable rupee, RBI ensuring durable liquidity through forex intervention and OMOs, are positives, imminent tightening policy by the RBI, concerns over fiscal slippages and higher than expected pick-up in growth can play spoilsport and lead to significant hardening of bond yields.

With rate cuts mostly out of the picture, the million dollar question is when the RBI’s policy tightening will begin.

Some of this has already been factored into the yields which have moved up notably in the past two months. Hence, on a base case scenario, the yield on the 10-year G-Sec should trade in a narrow range of 25-30 bps in 2018, with a likely upward bias towards the end of the year.

(The article first appeared in The Hindu BusinessLine.)