Pull Back or Reversal

April turned out to be a brutal month for bonds. The RBI pushed back on rate cut hopes, geo-political tensions intensified, crude oil surged, global bond yields spiked up and foreigners sold Indian bonds.

Domestic bonds sold off with the 10-year Indian government bond yield moving up 11 basis points in April so far from 7.05% on Mar 29, 2024, to 7.16% on April 23, 2024.

These developments posed a crucial question - Is this a temporary pull back or reversal from the downward trend in yields?

We see it more like a temporary pull back than a trend reversal. Our assessment is based on following:

Limited Global Influence

Much of the recent sell-off in Indian bonds can be attributed to the sharp rise in US treasury yields which has been on up move since start of the year. Currently at 4.63%, the 10-year US treasury yield is up 43 basis points in April so far. From year till date, it is higher by 77 basis points.

Chart – I: US treasury Yields moved up on resilient US economy and stubborn inflation

Source – Bloomberg, Data upto April 22, 2024

On the back of falling inflation last year, the US Fed had guided for upto three rate cuts in 2024. But, with the recent stickiness in inflation numbers above 3% and relative strength in employment and growth numbers, many fed officials have dialled back their rate cut expectations.

The Fed Chairman Jerome Powell said “recent data have clearly not given us greater confidence” that inflation is moving towards the FED’s 2% goal. Clearly, rate cuts are not coming as soon as was expected earlier.

Chart- II: US inflation remained sticky above 3% and labour market resilient with unemployment rate below 4%

Source – Bloomberg, Data upto March 2024

However, from India’s perspective, one should appreciate that the recent inflation disappoints have been quite a US specific phenomenon. While the inflation in other parts of the world have been turning incrementally softer.

In India too underlying inflation has been on a downward trend, much below the RBI’s 4% target (refer The last Mile). In March 2024, the headline CPI inflation fell to 4.85% from 5.09% in the previous month. At the same time, the CPI ex-vegetable which captures around 94% of the total CPI basket, fell to 3.55% (vs 3.77% in Feb 2024) and the core CPI (ex-Food and Fuel) fell to 3.26% (vs 3.34% in Feb 2024).

Chart – III: Underlying inflation trending below 4% while the Headline CPI remaining elevated due to volatile vegetable index

Source – MOSPI, Quantum Research; Data upto March 2024

Clearly, India’s inflation trend is more domestic than global. We expect the divergence between the US and India inflation trends to persist going forward.

Unlike the US, domestic consumption demand in India is muted due to limited fiscal support and weak rural economy. Furthermore, the government is on a path of faster fiscal consolidation in India against a fiscal loosening in the US. Thus, any rapid recovery in the domestic consumption demand looks unlikely in near future. This should keep the India inflation on downward trend.

Chart - IV: Continued Fiscal consolidation in India to keep Inflation under check while fiscal loosening in the US is limiting impact of monetary policy on inflation

Source – IndiaBudget.gov.in, St. Louis Fed
India Fiscal deficit numbers are for financial year ending March 31st; while US fiscal numbers are for calendar year ending December 31st.

Bull case for India Bonds Intact

We continue to hold our positive outlook on Indian bonds (refer The Bull Case) supported by a structural shift in demand supply balance, and a cyclical turn in inflation and monetary policy.

India’s inclusion in the global bond indices and rapidly growing domestic financial savings will continue to boost demand in the bond market. At the same time, government’s fiscal consolidation is reducing supply of bonds making demand supply balance in favour of long-term duration bonds.

India’s inflation is on a cyclical down-trend. We believe the recent shift in the US monetary policy outlook will not have any material impact on domestic inflation and monetary policy though it might keep Indian yields elevated for some time.

We see the recent selloff in the Indian bond market as a tactical opportunity to build long duration position with a medium-term outlook.

What should Investors do?

Considering a strong case for long term yields to decline over the next 1-2 years backed by the reasons described above, we believe long term government bonds offer a rewarding opportunity.

Dynamic Bond Funds are probably best placed to capture this opportunity with a flexibility to change if things don’t pan out as expected. However, investors need to have a longer holding period of at-least 2-3 years to ride through the intermittent volatility.

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

Source: Bloomberg, MOSPI, Quantum Research, IndiaBudget.gov.in, St. Louis Fed

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 Mile

- Time To Bond

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Above article is authored by Quantum.

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