Debt Monthly View for March 2024

Indian bond yields were range bound for most of March. The 10-year G-sec traded between 7.04% to 7.08%, broadly tracking the movements in the US treasury yields, ending the month at 7.05% (7.31% for March 2023). While the yields remained more or less unchanged on closing basis, markets did see some heavy buying interest mid-month, pushing the yields to 7.01% levels.

The 10-year US treasury yields hovered in the 4.18% to 4.32% range during the month, ending the month at 4.19%, thus broadly unchanged on closing basis. The swing in the UST yields was broadly in response to the mixed high frequency data sets released during the month, thus influencing the speculations around the timing and quantum of rate cut expectations by the Fed.

Crude oil prices also showed some volatility during the month, with Brent Crude prices moving up from $84/bbl in Feb end to ~$88/bbl towards the end of March as the supply/demand outlook tightened and global geopolitical concerns intensified.

Money market rates, however, surged higher due to persistent tightness in the liquidity condition. The 3-months Treasury bill yield rose up to end the month at 7.02% for March against 6.89% as of February end. Yield on the short-term money market securities such as commercial paper (CP) / certificate of deposit (CD) moved up as well. At the month end, 3 months maturity AAA PSU papers were trading close to 7.70%-7.85% levels.

Relative easing in liquidity conditions:

Banking system liquidity eased a little and moved into slight surplus on account of huge government spending towards the end of February. However, liquidity condition began to tighten again towards the third week of March moving into a deficit due to higher tax outflows. This led to the RBI resort to 6 VRR (Variable Rate Repo auctions – a lending tool by the RBI) in which banks showed major participation. Owing to some pick up in government spendings, the daily average liquidity for the month of March 2024 was close to a deficit of ~Rs 38,000 crores against a deficit of ~Rs 1,86,000 crores for the month of February. Much of the prevailing tight liquidity was due to slow pace of government spending in the previous months, leading to accumulation of huge government balances, while the core liquidity (banking system liquidity adjusted for government cash balance) continued to remain in a surplus of around Rs. 2 trillion.

Monetary policy outcome and Inflation:

In the April 2024 meeting, the Monetary policy Committee of the RBI kept the policy rates unchanged and maintained the stance as ‘withdrawal of accommodation’ with a 5:1 majority vote, thus delivering yet another ‘do-nothing policy’. On the liquidity front, the RBI decided to continue with its two-way operations through mix of instruments (VRR and VRRR) for the orderly evolution of money market rates.

While the RBI sought some comfort from falling core inflation and strength in Rabi production and the expectation of a normal monsoon, it continued to remain cautious on the inflation outlook in lieu of the evolving food inflation trajectory and its vulnerability to supply side shocks.

The CPI inflation remained flat at 5.1% in February 2024. 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 (3.4% y-o-y for February 24, below RBI’s 4% target).

Prevailing elevated crude oil prices do pose a risk to inflation. However, 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 by Rs 2 per ltr each. The 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.

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.

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

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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