On the back of a rather hawkish guidance from the RBI, B Prasanna, MD&CEO, ICICI Securities Primary Dealership, expects only one rate cut, at best, in 2015-16. In a interview with Aparna Iyer, Prasanna says bonds with 5-8 year tenures are the best buys now as supply through auctions could be low in this segment. Excerpts:
Bond yields have moved higher after the recent credit policy where there was a cut in the repo rate. Why this dichotomy?
Markets are always forward-looking. While an immediate repo cut was welcome, it was also accompanied by an extremely hawkish guidance on rates, including an upward revision in the January 2016 CPI projection to 6% from 5.8%. RBI clearly signalled that the 25-bps cut was front-loaded. In other words, there remains no room for rate cuts if inflation plays out according to RBI’s trajectory. There was also the subtle change in forward guidance with the statement dropping the accommodation stance. So, markets have reacted to the forward guidance rather than the cut.
What are the factors that will drive further policy easing?
Monsoon outturn and the government’s response to food price shocks, if any, will be major determinants of policy rate. The government’s decision to broadly stick to CACP’s recommendation on MSPs, attempts to tackle pulses inflation through imports and better-than-expected monsoon outcome are all encouraging and positive for the inflation trajectory. If CPI stays below RBI’s projected trajectory during the current year, there could be scope for one further cut. The recent rally in the bond markets is a result of this realisation. External factors like crude prices, Greece bailout resolution and rate normalisation in US are the risk factors.
But why is the yield curve at such a high spread over the repo rate in an easing cycle?
Demand supply dynamics have changed in the last couple of years and have become less favourable this financial year. First, OMO purchases have been discarded and, instead, RBI has made use of secondary market operations to suck out excess liquidity in the system due to BoP surplus. RBI had absorbed 26% and 28% of gross bond supply in 2011-12 and 2012-13, respectively. Second, foreign investors bought around $15 billion of government bonds, thus absorbing 15% of the gross borrowing in FY15. Since then, there has been no substantial increase in G-Sec limits for FPIs and, in fact, the bond market saw OMO sales totalling 10% of auctioned amount in the last fiscal. The gradual reduction in HTM (to 22% in September) is also affecting banks’ participation in auctions.
There has been devolvement in three consecutive auctions. Are the demand for bonds waning?
Demand for bonds comes from two quarters, one from participants who have regulatory requirements to hold them and other from traders and portfolio managers who take active calls on rates. HTM reduction is affecting bond purchase behaviour of banks. The appetite for Indian bonds remains high among global investors, but the limits are full. Domestic traders do not have the capacity to meet the supply-demand gap created by the absence of RBI & FII purchases without affecting the prices. Banks continue to buy G-Secs and maintain higher-than-required SLR as credit growth is still low. The spillover of lower demand is visible in long bonds because of market participants’ reluctance to add duration in a range-bound market.
Consequently, what would be the trading call right now?
Given that the yield curve is relatively flat beyond five years at an elevated level over the repo rate, I would prefer the 5-8 year segment, which sees the least supply in auctions and also has the advantage of higher carry per unit duration in an easy liquidity environment like the one prevailing currently. People desiring for a bigger bang for the buck could get in to longer duration with the caveat that the trade might underperform during a bull steepening.
When is Federal Reserve likely to tighten? What are your expectations on how global events will impact bond yields?
The Fed is on course to start normalistion of rates later this year and the June policy and accompanying economic projections made it clear that FOMC looks to end this calendar year with at least one 25-bps rate hike. The Fed could look to make the first move in September, but the market has not fully priced in a rate hike before December.
Emerging markets may face the brunt of high volatility, but India is much better positioned among peers to deal with such a situation. Given that FPI limits are full, we may not witness a selloff, but currency and equities could see some correction.