Debt Monthly View for January 2024

January 2024 marked some significant moves in both domestic and global bond markets. The 10-year US treasury closed the month at 3.97% (almost at the same level as at the start of the month) after witnessing some sharp moves during the month. The swing in yields was broadly in response to the FOMC keeping the policy rates unchanged, thus reinforcing the bets of no further rate hikes by the Fed and a rise in the odds of a rate cut by the Fed in March 2024.

In the domestic markets, bond yields eased as Bloomberg Index Services proposed including some Indian bonds in its emerging market local currency index from September 2024. This move would further enhance the already-rising inflows post JPMorgan's index inclusion that will take place in the month of June 2024.

The Indian 10-year benchmark bond yields eased from 7.21% to 7.14% during the month and saw another sharp drop in yields to 7.06% levels post the announcement of the Interim Budget February 1, 2024.  

Money market rates, however, surged higher due to persistent tightness in the liquidity condition. The 3-months Treasury bill yield was trading near 7.04% in Jan end compared to 6.94% in the previous month. Yield on the short-term money market securities such as commercial paper (CP) / certificate of deposit (CD) rose more than treasury bills. At the month end, 3 months maturity AAA PSU papers were trading around yields of 7.70%-7.75%.

Liquidity condition remained tight through the month with daily banking system liquidity deficit peaking around Rs 2.7 trillion. Towards the end of the month, the banking system liquidity saw some easing owing to bond redemptions. Much of the liquidity tightness was due to slow pace of government spending while the core liquidity (banking system liquidity adjusted for government cash balance) continued to remain in a surplus of around Rs. 1.8 trillion.

Interim Budget Review:

The key highlight of the interim budget was the government’s commitment to fiscal consolidation. In the budget 2021, the government had set a target to reduce fiscal deficit/GDP to 4.5% by FY 2025-26 from 6.8% in FY 2021-22. Following this glide path, the government lowered the fiscal deficit/GDP to 5.8% in FY2023-24, below the budget estimate of 5.9%. For the fiscal year 2024-25, the fiscal deficit is pegged at 5.1% of GDP.

With faster fiscal consolidation, government’s market borrowing is also budgeted to fall in FY25. The gross market borrowing is budgeted at Rs. 14.13 trillion in FY25 against Rs. 15.4 trillion in FY24. Given the rising demand for bonds from domestic investors like pension, PF, insurance etc. and India’s inclusion in the global bond index, supply of government bonds in FY25 might fall short of total demand. This will put downward pressure on interest rates going forward. 

Monetary Policy Expectation:

The RBI will deliver the outcome of its bi-monthly monetary policy meeting on the 8th of February 2024. For almost a year now, the RBI has left the repo rate unchanged at 6.5% to contain inflation.

While the headline CPI inflation has been elevated lately owing to volatility in food prices, the Core CPI, (which excludes food and energy prices) has been declining consistently over the last twelve months (3.9% y-o-y for December 23, below RBI’s 4% target). Based on the current trend, we expect the Core-CPI to fall to around 3.4% by Mid-2024. We expect the RBI to look through the temporary volatility in food prices and seek comfort from the declining core inflation and strong domestic growth.

The RBI is likely to keep the policy rate unchanged in the upcoming monetary policy while there could be a change in the policy stance from “withdrawal of accommodation” to “neutral”.

The RBI may announce some measures to address the persistent liquidity challenge in the banking system. Based on the historical trend of cash withdrawals, around Rs. 2 lakh crores can go out of banking system between February and May. Thus, a durable liquidity solution is required. The RBI might announce LTROs (long term repo operations) or FX swaps to infuse liquidity in a time bound manner.

Another key thing to watch in this policy would be the MPC’s voting pattern. After the last monetary policy, some MPC members openly advocated for a rate cut. This time, we might see a split voting on rates with one or two MPC members voting for a rate cut.

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

We expect bond yields to decline over the coming months. 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

Above article is authored by Quantum.

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