The Monetary Policy Committee (MPC) of Reserve Bank of India (RBI) raised repo rate by 25 basis points (bps) for the second time in two meetings. Given rising inflation and various upside risks to future trajectory, the rate hike was warranted. However, by delivering two back-to-back rate hikes, it has reaffirmed its proactive approach towards inflation targeting. This will boost investors’ confidence about the RBI and hence will support the Indian rupee and local debt. Apart from rate hike, the RBI maintained a balanced tone over future inflation trajectory. It acknowledged the risks from hardening input prices, rising inflation expectations and fiscal slippage. However, it chose to wait for the actual impact of revised minimum support prices (MSP) but at the same time factored in the effect of the reduced GST rates on various consumer products.
Despite the higher MSP announcement, bond market investors’ sentiment has improved considerably since the middle of June. We believe this revival was due to two major developments. State-owned banks have restarted their activity in the bond markets which has addressed the issue of demand-supply mismatch to some extent; and secondly, the market has dialed back the possibility of sustained rally in the crude oil prices after the agreement between major oil producing nations to boost supply.
These two developments along with lower than expected headline CPI print for May and June revived the confidence in bond markets. Bond yields across the curve, except for up to one year maturity treasury bills, fell since the RBI’s last policy meeting in June. The 10-year government security yield fell from the high of 8% after the June policy to touch 7.7% on this policy announcement.
On the other hand, the one-year Treasury bill rate rose by around 28 bps during this period as money markets adjusted for the expected rate hike in August and also to the tighter liquidity conditions in the second half of the year. Going ahead, the market interest rates will be driven by factors like domestic inflation trajectory, movement of global rates and currency and demand-supply dynamics in local bond market.
The core-CPI inflation (inflation calculated by removing prices of food and fuel) has grown by an average of 0.52% on monthly basis in last 12 months. Though we may see some deceleration in core inflation trend in coming quarters it may remain well above the RBI’s comfort zone. The government’s push to increase rural income, increased government spending and rising input costs pose additional risks. The RBI has kept its one year forward (April-June 2019) inflation forecast at 5%. We believe the risk is tilted on the upside to this projection and hence the RBI may need to hike the policy rates by another 50 bps in next 12 months.
A major factor influencing bond yields is demand-supply dynamics. The central government, in response to hardening bond yields, had decided to borrow a lower proportion (48% vs 60%-65% usual trend) of total requirement during April-September 2018 period. So the issuance of central government securities may rise substantially in the second half. Additionally, a major portion of states’ loan issuances had been cancelled during April-June 2018 due to poor demand. This increased supply may also hit the market in second half.
We continue to maintain our neutral stance on bond market rates over the medium term. However, short maturity bonds look attractive at current valuations. We always advise investors to have a longer time frame if they invest in bond funds and also note that the bond fund returns can be highly volatile or even negative in a shorter time frame.
-Pankaj Pathak is fund manager, Fixed Income, Quantum AMC