Looking Through the Noise

In the bond market, the sentiment pendulum has swung from one extreme to another over the last two months. Relentless rise in the US treasury yields and surprise jump in domestic inflation have rattled the investor sentiment in the Indian bond markets pushing bond yields higher and prices lower.

The 10-year Indian government bond (Gsec) yield which had fallen to lows of 6.95% in May, has jumped to the peak of 7.26%, before pulling back to the current levels of 7.22% on August 21, 2023.

Chart – I: Indian yields tracking UST, Crude and Inflation on way up

Source – Refinitiv, Quantum Research, Data as of Aug 21, 2023
Past Performance may or may not sustain in future

The underlying forces driving the bond yields over the last two months, continue to remain uncomforting -

• The US 10-year treasury yield, after rising sharply from levels of 3.5% during May 2023, is now holding above 4.2%
• The Crude oil price has risen more than 16% over the last two months and is still holding above the USD 85/barrel.
• The headline consumer price inflation in India jumped to 15 months high of 7.44% in July 2023 and expected to remain elevated for the next few months.

Chart – II: US treasury yields moving higher on resilient growth data and heavy supply

Source – Refinitiv, Quantum Research, Data as of Aug 21, 2023
Past Performance may or may not sustain in future

Tipping Point

The recent significant jump in the US treasury yields seems justified given - (1) the resilience shown by the US economy and the labour markets, and (2) sharp jump in treasury issuances.

However, for long term yields to go even higher and sustain there would require incremental strengthening of economic activity and serious worsening of future inflation trajectory. These conditions seem unlikely to hold given the synchronised global monetary policy tightening will continue to put restraint on demand.

We also note that interest rates in most of the developed world are at a level not seen in long time. The financial system in many places including the US is not accustomed to this high interest rates. This makes the financial system vulnerable to shock if the current level of US treasury rates sustains for long or move higher.

We have seen some short episodes of financial system vulnerabilities during September 2022 in the UK pension funds and during Mar 2023 in the US regional bank crisis. Once again, the financial condition in the US is tightening quickly. This is at a time when the corporate default rate is also showing an uptick.

In our opinion, the financial system risks should outweigh the supply risk in the US treasuries. We see higher probability of long-term US treasury yields coming down than moving higher.

Inflation havoc

In India, the inflation momentum was falling since start of the year until May, when vegetable prices started to rise sharply. The CPI inflation spiked to 15 months high in July to 7.44% as against average inflation of 4.65% between April- June 2023.

However, the pickup in inflation was not broad-based. It was almost entirely contributed by the sharp surge in food prices especially that of cereals (11.02% yoy), Milk (8.02%), vegetables (33.96%), pulses (12.08%) and spices (20.09%).

These items constitute 27.2% of the CPI basket but contributed more than 65% to the total headline inflation in July. Rise in tomato prices alone contributed 114 basis points to the headline CPI.

CPI inflation excluding vegetable remained same as the previous month at 5.4% in July. The Core CPI which excludes the volatile food and fuel prices, dropped to 5.0%.

Chart – III: CPI Inflation spiked to 15 months high led by surge in food prices

Source – Mospi, Quantum Research, Data as of Aug 14, 2023
Past Performance may or may not sustain in future

Going by the history, impact of vegetable prices should be transitory. As the fresh produce come in September-October, vegetable prices should fall. We are already noticing some cooling off in the prices of tomatoes.

Although kharif sowing started late due to delayed monsoon, it picked up quickly during July and August as monsoon spread widened. As on August 18, 2023, overall area sown under Kharif crops stood at 102.3 million hectares which is 0.1% higher than previous year.

Chart – IV: Kharif sowing started late but recovering fast

Source – Agricoop, Data as of Aug 21, 2023

Nevertheless, there could be some more upside pressure on cereals due to rising international prices and on pulses due to lower sowing during the current Kharif season.

There is also a risk that lower rainfall in some areas could affect the quality of kharif production and the Rabi sowing later in the year which mostly depends on the accumulated water during the southwest monsoon.

Chart- V: Uneven Monsoon distribution poses risk to Rabi Crops

Source - IMD, Agricoop, Data as of Aug 21, 2023

The government has a decent history of keeping food prices under check by proactively managing the demand supply in the market. As food prices moved up, they have started to intervene actively through open market sale of many impacted food items like rice, pulses, tomatoes, and onions. We expect these supply side interventions to bring down the food inflation over coming months.

For the non-food inflation, we continue to expect the disinflationary momentum to continue (Past, Present and Future of Inflation) as the sluggish recovery of consumption demand and expanded corporate margins would keep prices stable at the consumers’ level. Slowing Chinese economy should also be helpful in keeping commodity prices under check.

To summarize, the headline CPI might remain elevated for the next 2-3 months due to vegetable prices. It could also push the average CPI for the FY24 to near or above 5.5%. However, much of it is due to a transitory price shock in vegetable price in the last two months and have no impact on the underlying inflation momentum.

We expect the headline CPI inflation to converge towards the Core CPI Inflation of 5% by the early 2024.

Bond Outlook

The near-term uncertainty about the global interest rates and domestic inflation might keep bond yields elevated in near term. However, looking through all the near-term noises, the medium-term outlook for bonds looks favourable supported by peaked policy rates, comfortable liquidity condition and strong external position.

After recent rise in bond yields, valuations have also improved. We see limited upside in yields from current levels as the overall macro backdrop is favourable.

In line with this view, we would use every rise in yield to extend the portfolio duration by accumulating long term bonds in a staggered manner.

What should Investors do?

With most of the government bond yield curve above 7.2%, there is decent accrual available at current levels. Even in the real term (adjusted for inflation), government bonds are offering meaningful positive real yield. With expected CPI inflation of 5.2% (RBI’s Q1FY25 inflation estimate) and a 1-year Gsec yield at 7%, the real yield is around 180 basis points.

Chart- VI: Real yields are positive and reasonably high

Source – Refinitiv, Quantum Research, Data as of Aug 21, 2023

Investors with 2-3 years holding period can consider Dynamic bond funds which have flexibility to change the portfolio positioning as per the evolving market conditions.

Investors with shorter investment horizons and low-risk appetites should stick with liquid funds.

Portfolio Positioning

For any queries directly linked to the insights and data shared in the newsletter, please reach out to the author – Pankaj Pathak, Fund Manager – Fixed Income at [email protected].

For all other queries, please contact Neeraj Kotian – Area Manager, Quantum AMC at [email protected] / [email protected] or call him on Tel: 9833289034

Read our last few Debt Market Observer write-ups -

- The Last Lap
- Are Long Bonds Overvalued?

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Above article is authored by Quantum.

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