Debt Monthly View for May 2024

After a brutal April, May 2024 brought cheer to the Indian bond markets. A record high RBI dividend, an upgrade in India’s rating outlook to “positive” from “stable” by S&P after 14 long years and optimism around improving inflation data in the US economy enlivened the bond markets.

The 10-year US treasury yields cooled by ~18 bps in May as fears of persistently high inflation began to tail-off. The US CPI remained steady at 3.4% y-o-y in April mainly on account of elevated housing prices. The Fed left the policy rates unchanged in its May policy and Fed chair Powell stated that the central bank’s next policy move would be to lower rates even with hotter than expected inflation data. This led to the markets breathe a sigh of relief and the US 10-year yield dropped to 4.57% on 3^rd of May 2024 and ended the month at 4.503%.  Nonetheless, sticky inflation and strong labor market continue to pose an upside risk to the US treasury yields.

Tracking the US treasury yields, Indian bond yields too cooled off from 7.20% levels as of the end of April. However, major move was observed after the announcement of a record high dividend by the RBI favoring the demand supply dynamics. The 10-year benchmark yield moved from 7.159% as of 3^rd of May to 7.056% by the 31^st of May 2024.

Markets gained added positive support from India’s rating outlook upgrade from S&P.  The agency stated that the positive outlook reflects their view that continued policy stability, deepening economic reforms, and high infrastructure investment will sustain long-term growth prospects. That, along with a cautious fiscal and monetary policy that diminishes the government's elevated debt and interest burden while bolstering economic resilience, could lead to a higher rating over the next 24 months.”

While the global geopolitical concerns lead to some volatility in the crude oil prices during the month, on a month-on-month basis, Brent Crude prices corrected to $82/bbl end of May from ~$87/bbl towards the end of April (same levels as that of March end).

Money market rates too cooled off slightly. The 3-months Treasury bill yield ended the month at 6.89% for May against 7.01% for April.  This 10-15 bps move was largely after the Government’s announcement of a cut in its T-bill issuances by Rs 600 billion till June 2024. Yield on the short-term money market securities such as commercial paper (CP) / certificate of deposit (CD) too plunged owing to surplus liquidity at a banking system level. At the month end, 3 months maturity AAA PSU papers were trading close to 7.30%-7.35% levels.

Relative easing in liquidity conditions: Banking system liquidity eased considerably and remained in modest surplus for most parts of April. Moving to May, average monthly liquidity was in a deficit of Rs 1.43 trillion for May against a surplus of Rs 0.20 trillion for April.

The prevailing deficit liquidity at banking system level led the RBI to attempt VRR and buy-back during the month. However, the RBI managed to repurchase bonds worth Rs 0.17 trillion, falling short from its Rs 1.6 trillion target. Core liquidity too continues to remain in a surplus of ~ Rs 3.5 trillion. We believe liquidity conditions shall slowly improve post elections, accounting for potential spending increase in the first half of the fiscal year.

RBI declared record high dividend:

The RBI announced a dividend of Rs 2.1 trillion (0.6% of GDP), significantly higher than the market estimates and Government’s dividend estimate in the interim budget for FY25 as well. We believe such large dividend is on the back of higher interest income on foreign securities. RBI’s foreign currency assets (FCA) rose by 13.8% y-o-y in FY24 (period up to 29th of March 2024), largely led by FX reserve accumulations.

However, such the hefty RBI dividend does make room for a reduction in issuance of G-sec and T-bills, thus assisting with the fiscal consolidation plan or impacting liquidity management.  The surplus dividend could swell up the Government balances (~ Rs 2.5 trillion as of May 2024) and is likely to boost the durable liquidity. Any reduction in T-bill issuances shall have a positive impact on liquidity.

Inflation:

While there has been a broad-based moderation in inflation over the last few months, volatility in food inflation has kept the headline number slightly elevated. The headline CPI inflation remained steady at 4.83% for the month of April. At the same time, the CPI ex-vegetable which captures around 94% of the total CPI basket, fell to 3.22% (vs 3.77% in Feb 2024) and the Core CPI (ex-Food and Fuel) also corrected slightly to 3.2% (vs 3.34% in Feb 2024, below RBI’s 4% target).

The RBI estimates CPI inflation to fall to an average of 4.5% in FY25. We see high probability of a downward surprise to this inflation estimate. In our opinion, the true extent of disinflation is underestimated in the headline CPI numbers owing to volatile food prices. The ex-vegetable CPI, which captures about 94% of total CPI basket, is trending well below 4% now. Based on the current trend, the core CPI (ex-food and fuel) will likely remain below 3.5% for the entire FY25.

Easing inflation pressure should lower the inflation risk premium on bonds by reducing the yield spread on government bonds over the policy repo rate. This in turn can bring down the bond yields even without a rate cut by the RBI. Any increase in the rate cut probabilities would further intensify the downward trend in bond yields.

General elections results and its impact on the bond market:

The outcome of the 2024 general elections varied significantly from the broad market opinion and exit polls forecasts. The National Democratic Alliance (NDA) shall form the government, with Narendra Modi securing a third consecutive term as the Prime Minister (Modi 3.0), although it puts an end to a decade long single-party majority.

Amid the early polls, in response to the opposition’s unexpected strong performance creating uncertainties, the 10-year G-sec yield moved up from 6.95% levels on a day prior to the election outcome to 7.06% levels, closing the day at 7.04%. However, we saw a reversal the very next morning where the bond yields opened the day at 7.02% levels and remained ranged for most part of the day. That being said, we believe this surge in yields was merely a speedbump on the path of lower bond yields as India’s macro-stability factors are supportive of our positive outlook on bonds in the near term.

Demand – supply dynamics look favorable: The central government has pegged its gross market borrowing at Rs. 14.1 trillion in FY25. This is Rs. 1.3 trillion lower than the FY24 market borrowing of Rs. 15.4 trillion. Additionally, the H1FY25 borrowing is pegged at Rs. 7.5 trillion or 53% of total bond annual supply. This is significantly lower than the typical trend of around 60% H1 supply. Thus, lower supply shall work in favor of bonds.

On the other hand, the strong demand from FPIs ahead of the global bond index inclusion and other market participants like Pension Funds and Insurance is likely to persist, which is expected to be an added positive for domestic yields.

Outlook

We hold a positive outlook on the fixed income market considering:

• Favourable demand supply mix in government bonds
• Increasing participation by foreign investors with index inclusion
• Declining Inflation trend
• Possibility of rate cuts by the RBI
• Softening global environment with declining global growth and expectation of rate cuts by major central banks

The recent sell-off in the bond markets amid the uncertainty around the outcome of the general elections could be a good opportunity to lock in high yields. With higher starting yield and possibility of decline in bond yields over medium term, return potential of fixed-income funds investing in long duration bonds look good. Long term bonds tend to perform better during falling interest rate environment.

Investors with 2-3 years holding period can consider dynamic bond funds for their fixed income allocation.  Dynamic bond funds have flexibility to change the portfolio positioning as per the evolving market conditions. This makes dynamic bond funds better suited for the long-term investors in this volatile macro environment.

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, CCIL & Bloomberg

Above article is authored by Quantum.

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