Debt Monthly View for September 2023

September was an eventful month for the bond market with a series of market moving developments. On the negative side, US treasury yields, and crude oil prices moved higher putting upward pressure on Indian bond yields. While on the positive side, sharper than expected drop in CPI inflation and the news of India’s inclusion into the global bond indices boosted the market sentiment.

During the month, the 10-year benchmark government bond yield oscillated between 7.10%-7.25% and at the end closed at 7.21%, compared to 7.17%.

Short term yields also closed higher in September due to tighter liquidity conditions ahead of the quarterly closing. The 1-year G-Sec yield went up to 7.05% from 7.00% a month ago.

Money market rates also surged higher with the 3 months Treasury bill trading around 6.83%-6.85% at the month end. The 3 months AAA PSU Commercial paper (CP)/Certificate of Deposit (CD) were trading 25-30 Bps above the respective maturity T-bills.

Hawkish FED & Boiling Brent Crude

The 10-year US treasury yields have gone up to 4.69% during the month and closed at 4.57% against 4.10% in the previous month. The US Federal reserve left its key rates unchanged at 5.25%-5.50% as expected but stiffened a hawkish monetary policy stance. The 10-year US treasury again went up to 4.68% in first week of October, as US government averted the shutdown.

FOMC’s dot plot projection signalling another rate hike and more gradual pace of moderation in interest rates over next two years. It also raised the economic growth projection for the US economy in 2024.

Crude oil prices surged in the past month due to supply cuts by OPEC+ and falling inventory levels. Brent crude went up to $98 per barrel during the month and closed at $95 per barrel, although it gave up its gains and traded around $90 per barrel in the first week of October on the back of dampening traders' sentiments amid a strong dollar and raising US Treasury yields.

Given the upcoming election season, we do not expect higher crude oil prices translating into increase in domestic fuel prices in near future. However, sustained rise in global crude oil prices might weaken the investor sentiment in the bond market.

India’s Bond Index Inclusion

India will be included in the JP Morgan EM bond index from June 28, 2024, with a weight of highest permissible weight of 10% of the index. This will be staggered over 10 months with 1% increase every month.

India’s inclusion in this index will likely attract $25-40 Billion over next 12-18 months including passive and active flows. The active participant will likely front run the move 3-6 months before actual bond index inclusion. This has also increased the probability of inclusion into other global bond indices which can attract more foreign inflows.

This will also change the demand supply dynamics. In H2FY23, Gross G-sec supply is pegged at Rs. 6.55 trillion with net supply of Rs. 3.8 trillion due to higher bond maturities in the second half. Given the past trend, combined demand from Banks, Insurance, Pension and PF will be more than total net supply. If active FPI flows start coming, there should be significant downward pressure on yields.

Liquidity Conditions Tightened

On September 8, the RBI decided to roll back the Incremental CRR (I-CRR) (Incremental Cash Reserve Ratio - Review) in phased manner. During the last month, it reversed half of the ICRR amount in two tranches adding ~Rs. 550 billion into the banking system liquidity. The remaining 5% ICRR (~Rs. 550 billion) will be reversed on October 7, 2023.

Despite the liquidity addition from I-CRR reversal, the liquidity condition in the banking system tightened. Banking system liquidity during the month dropped to deficit of Rs. 0.11 trillion on daily average basis, as against the surplus average of Rs. 1.11 trillion in the month of August. The liquidity deficit was mainly contributed by the quarterly tax outflows. Though the core liquidity which excludes the government balance increased marginally from Rs. 2.5 trillion to Rs. 2.6 trillion.

The risk to the inflation trajectory might emanate from the deficient rainfall negatively impacting the food production.

Moderation in Food prices

The Consumer Price inflation moderated in the month of August to 6.83% YoY vs 7.44% in the previous month. The Moderation in CPI inflation is largely driven by food basket. Food inflation is eased by 9.2% against 10.6% in the prior month. While Core Inflation is also moderated to 4.8% YoY, lowest level in three years.

Going forward CPI inflation is expected to drop further due to softening vegetable prices. Although increasing pulses and cereal prices might pose risk going ahead. While reduction in prices of LPG cylinders by Rs. 200 from 30th August 2023, may slightly bring down the CPI print. We expect the headline CPI to fall back to near 5% by the year end. We expect the CPI inflation to average around 5.3% in FY24.

Outlook

We expect the Indian bond yields to remain in the broader range of 7.0%-7.3% over the coming months, tracking crude oil prices and the US treasury yields.

Longer term outlook of bonds looks more favourable, as the rate hiking cycle is near end in most economies around the world and rate cutting cycle can start early next year. Given the index inclusion, the demand supply dynamics also look favourable for long end bonds.

Investors with 2-3 years investment horizon and some appetite for intermittent volatility, can continue to hold or add into dynamic bond funds.

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, QMF

Above article is authored by Quantum.

View All