25 bps rate cut like out of rate-setting cycle, if budget is good
Tue, 09 Feb 2016 10:08:55 -0700
Both lending rates and bond yields are higher than where everyone, including the RBI wants to see it at this stage of the cycle
Debt instruments are assets that require a fixed payment to the holder, usually with interest. Examples of debt instruments include bonds (government or corporate) and mortgages. Types of debt instruments include notes, bonds, certificates, mortgages, leases or other agreements between a lender and a borrower.

From a long-term investors’ perspective, the 30-year bonds at 8.25 per cent seem extremely attractive given that the repo rate stands at 6.75 per cent with expectation of it falling to 6.5 per cent after the budget. This difference in the yield between the repo rate and bond yield, (known as term spreads- currently 1.5 per cent on the 30-year bond and 1 per cent on the 10-year bond) is high. CPI inflation as per RBI projection could come down to 5 per cent level by January 2017, which will induce RBI to cut repo rates in the coming months, which makes long-term bonds attractive.

What’s driving the bond yields high?
As we know, price is a function of demand/supply. Higher the supply over demand; lower should be the price of the product. That is what is largely playing out in the bond market. The supply of longer tenure bonds (above 10 years) has been higher than the demand for it. This has led to a fall in the prices of these bonds and, hence, an increase in the yields. Long-term buyers, knowing that demand is low, have been demanding a higher term premium to buy these bonds at successive government bond auction; resulting in an increase in its yields.

Another factor driving yields higher has been due to the worries over the increase in the government’s fiscal deficit next year (the difference of government revenue and expenditure, which is funded by borrowing).

Also, our state power companies, which are saddled with losses, will now be allowed to convert their loans into bonds resulting in further supply of bonds in the market. Even the RBI's open market operations* (OMO – where they buy government bonds from the market) has failed to cheer market participants even though RBI accepted the bids at the long end of the yield curve.

Given this scenario, the markets need assurance of further buying support or else we expect the yields will continue to trend higher.

Economic indices in India...
CPI inflation was clocked at 5.61% levels for the month of December 2015, with food inflation coming at 6.40 %, primarily due to pulses, meat and fish showing higher increases. The inflation for the month of January is expected around 5.35% levels as the fall in vegetables and pulses have not been captured to a large extent in the December 2015 CPI inflation Data.

The April- December 2015 fiscal deficit was 88% of the full year target , which makes achieving 3.9 % fiscal deficit target achievable for the current financial year.

The rupee was volatile and traded close to 68 against the US dollar as FII pulled out USD 1.75 Billion in the month of January 2016.

...And across the world
Global markets continued to be volatile due to China’s efforts to engineer the depreciation of its currency – the Yuan. A weaker Yuan will make Chinese exports more competitive in the global markets; however this move is leading to record fund outflows from Chinese markets.

Japan is experimenting with negative interest rates for its depositors to induce consumption to achieve its CPI inflation target of 2%. The US Federal Reserve having hiked the Fed Funds rate for the first time in eight years in December remained on hold in its January review.

The US bond markets have begun to price in a scenario where they don’t expect any major rate hikes from the US Federal Reserve.

Coming to the RBI policy review
The RBI left the key rates unchanged with the Repo rate remaining at 6.75%. Post the ‘front-loaded’ 50 bps cut in September, we had expected RBI to remain on hold till the Union Budget.

Here is a quote from the speech given by the governor - Dr Rajan, on the Indian economy and the way the RBI sees it.
“The Indian economy is currently being viewed as a beacon of stability because of the steady disinflation, a modest current account deficit and commitment to fiscal rectitude. This needs to be maintained so that the foundations of stable and sustainable growth are strengthened. The Reserve Bank continues to be accommodative even as it leaves the policy rate unchanged in this review, while awaiting further data on the development of inflation.

Structural reforms in the forthcoming Union Budget that boost growth while controlling spending will create more space for monetary policy to support growth, while also ensuring that inflation remains on the projected path of 5 per cent by the end of 2016-17.”

RBI is rightly waiting for the government's fiscal response. Although a small fiscal slippage is unlikely to impact inflation significantly, but the need to maintain fiscal discipline is imperative to keep investor sentiment buoyant.

The government missed a historical opportunity to clean up the bank and fiscal balance sheets by utilizing some extra fiscal space when it presented the last budget.

In July 2014, market sentiments towards Modi and India were high, and an increase in fiscal deficit by 0.5%, even in the garb of cleaning the “mess”, would have allowed them to adequately recapitalize PSU banks, clean up the fiscal accounts and start afresh with a cleaner balance sheet. They didn’t do it then and will have to now wait for a normal economic recovery to sort out the mess.

You can sense the government desperation now in increasing public investment to boost growth and thus the oft repeated statements on wanting to relax the fiscal targets. We believe it could backfire as investors take it as a sign of government not honoring its commitment. India needs foreign and domestic investors to maintain its positive sentiment and thus should maintain fiscal prudence.

If the RBI is convinced of the government’s intentions of keeping spending under check and still provide some investment boost, given that the RBI decides to remain in accomodative mode, we expect an inter-meeting cut post the Budget of 25 bps. Thus taking the Repo Rate to 6.5%; 1.5% higher than its 5.0% CPI target for March 2017.

Till then, the RBI will have to focus on monetary policy transmission. Both lending rates and bond yields are higher than where everyone, including the RBI wants to see it at this stage of the cycle. Lending rates will fall post the implementation of Marginal cost of deposits from April 1 2016.

Bond markets though need some buying firepower support, which can only be provided by the RBI now. Although, RBI will not expressly state its desire to conduct OMOs, we believe there would be some more OMOs to cover the core liquidity deficit (adjusted for government balance) and to adjust for its own previous OMO sales. Bond yields continue to remain attractive across the curve but the demand supply satiation is impacting the longer end of the curve to a large extent.

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