Debt Monthly View for April 2024

April panned out to be a brutal month for the bond markets. Elevated crude oil prices, re-emergence of geo-political tensions and inflation worries in the US led bond yields to climb higher.

The 10-year US treasury yields moved up ~49 bps in April from 4.19% to 4.68% as fears of persistent inflation re-emerged. The US CPI rose to 3.5% y-o-y in March on account of elevated housing prices and gasoline prices edging upward too. These worries led to the bond market dialing back rate cuts expectation in 2024.

Tracking the US treasury yields, Indian bond yields too surged higher during the month of April. However, favorable demand supply dynamics owing to lower government bond issuance and bond index inclusion and a stable rupee supported the Indian bond yields. The 10-year Indian government bond (IGB) yield moved 15bps during the month from 7.05% to 7.20%.

Money market rates too came down with the 3-months Treasury bill yield ending April at 6.92% against 7.01% at the March end. Yield on the short-term money market securities such as commercial paper (CP) / certificate of deposit (CD) plunged owing to surplus liquidity at a banking system level. At the month end, 3 months maturity AAA PSU papers were trading close to 7.20%-7.30% levels.

Relative easing in liquidity conditions: Banking system liquidity eased considerably and remained in surplus for most parts of April. Average monthly liquidity was in a surplus of Rs 260 billion for April against a deficit of Rs 380 billion for March aided by a huge government spending towards the end of March and April. Liquidity condition tightened again by the April end to deficit of around Rs. 1 trillion.

Inflation:

Headline CPI inflation which has been elevated lately owing to volatility in food prices, moderated to 4.9% y-o-y for March 2024 and the Core CPI, (which excludes food and energy prices) which demonstrated a disinflationary trend softened further to 3.3% y-o-y for March 2024 (3.4% y-o-y for February 24, below RBI’s 4% target).

While the prevailing elevated crude oil prices pose a risk to inflation, the price passthrough between global crude oil and domestic fuel prices seems to be broken. In contrast to rising crude oil prices, the oil market companies have slashed prices of petrol and diesel. LPG prices were also reduced by around 11% in March. The full impact of these cuts on inflation is yet to be seen.

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.

Outlook

We hold a positive outlook on the fixed income market supported by structural shift in demand supply balance and cyclical turn in the inflation and monetary policy. We expect bond supply to decline over the coming years owing to government’s fiscal consolidation. While demand for bonds is likely to increase led by long term institutional investors such as insurance companies, pension, and provident funds etc. India’s inclusion in the global bond index will also boost the demand from foreign investors.

We also see a room for rate cut by the RBI as underlying inflation is trend below 4% and real interest rates are reasonably high. There is also a reasonable probability of global interest rate cycle turning downwards by end of this year. This provides a strong backdrop for Indian bond yields to go down.

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, Bloomberg

Above article is authored by Quantum.

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