Debt Monthly View for July 2024

The bond market maintained its positive momentum in July supported by increased foreign buying, a fiscally prudent budget and softer global backdrop. The 10-year Indian government bond (IGB) yield fell 8 basis points during July from 7.0% to 6.92%. It declined further to 6.87% (as of August 8, 2024) during early August following a sharp drop in the US treasury yields.

Short term money market rates too declined sharply during the month due to easing liquidity condition and a sizeable reduction in the treasury bills issuances by the government. The 3-months Treasury bill yield fell from ~6.80% at the June end to around 6.62% by the July end. Notwithstanding the drop in treasury bill yields, short term CD/CP rates remain almost unchanged around 7.15% (for AAA PSUs).

US FED heading for rate cuts

In the Federal Open Market Committee (FOMC) meeting held on July 30-31, 2024, the US Federal Reserve (Fed) left the interest rates unchanged at 5.25%-5.50%. However, it hinted at potential rate cuts in September acknowledging easing inflation pressures and rising unemployment.

Rate cut bets increased further after the July labor market data which showed a surge in the US unemployment rate to 4.3%. New job creation and wage growth rate also declined in July.

On this backdrop, the US treasury yields declined sharply with 10-year UST falling from 4.39% at the June end to a 12-month low of 3.77% on August 5, 2024 before rebounding to 3.91% as of August 8,2024. According to the CME FedWatch Tool, which monitors the implied forecasts of fixed income markets, the market is expecting the first interest rate cut in September 2024 (50 basis points with a 63.5% probability) and additional 50 bps cuts by the end of 2024.

Among other major economies, Bank of England (BOE) cut the policy rates by 25 bps while the Bank of Japan (BOJ) hiked policy rates from 0-0.1% to 0.25%. BoJ’s rate hike took the markets by surprise and resulted in a sharp strengthening of JPY triggering a panic selloff in risk assets across the globe in following days.

RBI maintained status quo

Despite significant global events, including the US recession concerns and financial market turbulence post BOJ rate hike, the RBI maintained its focus on domestic growth-inflation dynamics.

Going into the policy, there were some thoughts of RBI announcing OMO sale to suck out excess liquidity in the banking system which is currently hovering near Rs. 3 lakh crores. However, RBI seems comfortable with the prevailing surplus liquidity condition and guided to continue with VRRR operations to manage the liquidity on margins.

This move would allow the high surplus liquidity conditions to persist for a longer period keeping short term money market rates close to or below the policy repo rate.

Positive long-term inflation outlook amid near term volatility

CPI Inflation reached a four-month high in June, rising to 5.1% YoY from 4.8% in May. This increase was primarily driven by higher food prices, particularly vegetables. Excluding vegetables, headline CPI stood at 3.5% YoY; while the Core CPI which excludes Food and Fuel prices, was around 3.1% in June.

In July Headline CPI inflation might fall to 3.5%-3.8% due to favourable base effect. However, it is expected to bounce back to above 4% during the second half of FY25. On the other hand, we expect core CPI to jump closer to 3.9% in July and stay around that level due to reversal in base effect and increase in telecom tariffs. That being said, we remain comfortable with the overall inflation trend. A favourable monsoon and healthy sowing trend should aid decline in food inflation going forward.

Union Budget a strategic blend of growth and fiscal discipline:

India’s FY25 Union Budget focuses on fiscal discipline and deficit management. The government utilized the additional revenue from the RBI dividend to reduce the fiscal deficit at an accelerated pace and enhance spending in almost same proportion.

The targeted fiscal deficit for FY25 is 4.9% (compared to 5.1% in the interim budget), with a minor reduction in market borrowing. The government was reasonably conservative in its revenue assumptions and there is a possibility of the government overachieving its fiscal target.

Outlook

With key events behind us, the market will switch back to demand supply dynamics in the bond market and emerging inflation trend.

We maintain our positive stance on long-term bonds in view of the structural shift in the demand supply balance and the cyclical turn in inflation and monetary policy globally.

Growing demand for long-term bonds by domestic insurers and pension funds, along with foreign investors’ index-driven inflows, will bolster the bond market. Furthermore, easing monetary policies in advanced economies should aid a downward move in domestic bond yields as well.

In this declining interest rate environment, investors with medium to long investment horizon, should consider dynamic bond funds. These funds can allocate to long-duration bonds while keeping flexibility to adjust portfolio position if market conditions become unfavorable. This adaptability allows investors to remain invested for a longer period.

Investors with a short-term investment horizon and with little desire to take risks, can invest in liquid funds which invest in government securities and do not invest in private sector companies which carry lower liquidity and higher risk of capital loss in case of default.

Source: RBI, MOSPI, Bloomberg

Above article is authored by Quantum.

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