The year 2017 had been an exciting one for both bulls and bears in Indian bond market. The year started with the so called “reflation” story as global bond yields and commodity prices rose sharply post Donald Trump’s victory on expectation of higher global growth and inflation pickup. The Indian bond yields followed the global yields on the upward ride which was further accelerated by the RBI’s stance change on monetary policy. In February 2017, RBI changed its monetary policy stance to Neutral from accommodative, against market expectations, indicating equal chances of rate cuts and rate hikes.
Part of the global reflation trade fizzled out by the mid-year and at the same time the post-effects of demonetization and pre-effects of GST became visible on distorted Indian macro data points. Inflation and growth fell to multi-year low which forced RBI to cut policy rates in August by 25 basis points to take the Repo rate to 6.0%. It also induced a sharp rally in bond markets with the 10 year bond yield again moving below 6.5%. In the last quarter, bond market remained under a bearish trap on rising oil prices and increasing US Treasury yields. Moreover, the RBI also turned excessively cautious over inflation and market participants started pricing in possibility of fiscal slippage amid shortfall in revenues from RBI dividend and GST Tax collection.
Going into 2018, we can see the positive bond story of last four years turning. Inflation trajectory is showing signs of reversal, external account (current account deficit) is threatened by increasing oil prices and fiscal position is facing challenge from government’s dilemma over boosting growth and supporting farm incomes with an eye on the 2019 elections.
Despite cutting rates in August, RBI had maintained a cautious stance over inflation throughout the year which got further intensified towards the year end. Now, question is whether RBI’s concerns are real and if it warrants a rate hike in 2018? Will the Modi government compromise on fiscal consolidation and policies be based on political considerations ahead of 2019 general elections? How will policy normalization in advanced economies affect the capital flows into emerging markets?
Although inflation is showing some signs of firming up, RBI’s concerns over it seem overblown especially in an environment when economic growth is subdued and industries are going through very low capacity utilization. Rural wages are growing at a muted pace. Rising oil prices has emerged as a risk but considering the changing market dynamics in this sector, we do not expect this recent trend to sustain.
Nevertheless, we are concerned about any sharp rise in minimum support prices of food items amid farmers’ protests or any supply side shocks. Consumer inflation may rise above 5.5% by mid-2018 on distorted base effect but it will likely average around 4.5% in the year and remain anchored below 5% in 2019. In the last few years, government has implemented various structural reforms to address supply side issues in agriculture market. The effects of those will be more visible in next two years.
We expect that RBI will maintain status quo on rates because of two factors. First, the high real rate (repo rate minus CPI Inflation) is likely to sustain which will keep the demand side well anchored. Second, the growth recovery is in nascent phase and excessive hawkishness on policy front can hurt the recovery process.
The other major risk on investors’ mind is coming from the possibility of government deviating from the fiscal consolidation roadmap. We cannot rule out the possibility of a slight increase in fiscal deficit next year. But that would not be a signal of government moving away from its commitment on fiscal consolidation.
A slight increase in fiscal deficit may not materially alter the macroeconomic landscape if that expenditure goes into productive sectors. We will be more concerned if the government turns the policy focus more towards political considerations than economic sense, looking at general election in 2019. However, considering Modi’s confidence in getting re-elected, they may be wary of taking any step which could create bigger problems in the next term.
After five quarters of deceleration, economic growth is now showing signs of revival. We expect the growth will continue to recover but at a gradual pace. Government has implemented various structural changes in last few years to improve business environment in the country. One of the major move by government to boost growth is in recapitalizing the public sector banks which have been struggling with the problem of stressed assets.
The government’s bank recapitalization plan is a positive move in a direction to kick start the credit cycle but it could distort the bank’s demand for government debt/bonds. Currently, the public sector banks hold government securities over 30% of their NDTL (Net demand and time liabilities) against the regulatory requirement of 19.5%.
As credit growth picks up this proportion may fall which is a likely case in 2018. Additionally, the recapitalization bonds in bank’s books might also reduce their appetite for other bonds, though the structure of recapitalization bonds is still not clear.
Foreigners have been positive on Indian bonds since 2014. Fiscal consolidation, Real Rate targeting, High FX Reserves and falling Oil prices have been the foundation of the India bond story. Since start of 2014 till November 2017 foreign investors have poured in around USD 46 billion in Indian bond market despite withdrawal of quantitative easing and rate hikes in US. But will these flows continue in next year?
Given RBI’s commitment to maintain high real rates and continued progress on reforms, we expect foreigners will continue to favor Indian bonds. But flows may slow down in 2018 amid increased oil prices and risk of fiscal slippage. Moreover, we also need to be watchful of the global central banks becoming more synchronized over global growth/inflation outlook and policy actions.
Over the medium term, we will be monitoring the fiscal benefits coming from various schemes like GST, direct benefit transfer and aadhar. DBT and aadhar linking have significant potential to plug the loopholes in the system of welfare payments. As per government’s estimates, just one third achievement in DBT has saved the government Rs. 650 billion. So, as it expands it will likely reduce government’s expenditure on welfare schemes. Aadhar linking and GST will also provide tax authorities better information access and might lead to higher tax base over time.
If GST compliance improves and leads to higher tax revenues, it might provide government with enough resources to spend on rural sector without increasing the fiscal deficit. It could also lead to further reduction in GST rates over time which will have positive effect on inflation.
Bond markets have enjoyed a sharp rally in last four years which has now come to an end. Indian bond yields have increased quite a bit in the last 5 months. The 10-year government bond is now trading near 7.2%; which was at 6.4% in August.
The past year had been a sour reminder to investors that bond funds do carry market risk and can even return negative in adverse times. To recollect, at the start of this year in our 2017 outlook note, we had cautioned investors to “lower their return expectations from bond funds as the best of the bond markets were behind us. Capital gains would no longer be the driver of bond returns and investors should also prepare themselves for capital losses”.
At that time in December 2016, the 10 year bond yield was 6.3% and the entire government bond market was yielding below 7%. Now with most of the bond yield curve above 7%, the valuations have improved from a medium term prospective. However, we still remain cautious as yields could rise even higher from current levels amid various uncertainties.
We advise investors to have a longer time frame as far as investing in bond funds are concerned and should also always consider the possibility of capital losses in short term. Bond mutual funds invest in fixed income securities and unlike fixed deposits do not provide a fixed return.
For investors who are looking at debt mutual funds to their short term savings are better off investing in liquid funds. After a year of huge surplus, liquidity in the banking system is now close to neutral. We expect the liquidity condition to turn into deficit mode by next quarter. This could push short-term interest rates higher and provide opportunity to re-invest the short term assets at higher rates/yields. Since we do not expect RBI to cut interest rates, in this scenario, returns from liquid funds might improve over the last year and it could become a better surrogate to fixed deposits for short term savers.