What is key metric for investors to track bond market? Answer revealed

Published: October 16, 2017 3:39:40 AM

Going ahead, the bond market will face some tough times as fiscal and inflation risk play on investors mind in the backdrop of no monetary support from the RBI. However, valuations have become attractive after the recent sell-off.

The ascent of bond yield was in line in September with global yields after US Federal Reserve started the process of trimming down its .5 trillion balance sheet.

The ascent of bond yield was in line in September with global yields after US Federal Reserve started the process of trimming down its $4.5 trillion balance sheet. Media reports said that government may expand fiscal deficit to stimulate growth also hit the market sentiment. The 10 year benchmark bond yield rose by 14 basis points (100 bps = 1%) to end in September at 6.66% as against the close of 6.52% in previous month.

MPC of RBI

The Monetary Policy Committee (MPC) of the RBI kept the policy rates unchanged at 6% with a vote of 5-1. It retained the neutral stance to keep the CPI inflation near 4% (with +/- 2% deviation), while supporting growth. Though the move was broadly in line with our expectation, we anticipated a dovish tone from RBI reflecting on slower economic momentum. The RBI seemed optimistic about the growth recovery. It did cut its GVA estimates down to 6.7% from 7.3% for FY 18. It raised the CPI projection for H2FY18 marginally to 4.2%-4.6% and highlighted upside risk to inflation from farm loan waivers and fiscal slippage. Liquidity with commercial banks remained in surplus to the tune of Rs 2 trillion. We expect that liquidity surplus will come down as currency withdrawal from banks may increase during the festive months of October-December. However, the liquidity situation may still remain in surplus mode and RBI needs to continue the OMO (Open Markets Operations) sales to bring it to neutrality.

Fixed income outlook

Going ahead, the bond market will face some tough times as fiscal and inflation risk play on investors mind in the backdrop of no monetary support from the RBI. However, valuations have become attractive after the recent sell-off. Any increase in fiscal deficit remains the most critical risk to sentiment towards bonds and will be the key metric to track. A large increase (more than 0.5%/GDP) will be seen very negatively by the bond market and can lead to a further sell off in bonds. Anything less than that can be absorbed by the market even at current levels. In the current inflation targeting regime of 4% (+/-2%) headline CPI Inflation + (1%-2%) real interest rates, there is very little chance for repo rate to meaningfully sustain below 6%. Thus we maintain our medium term neutral stance over rates. However, we will keep looking for signs of mispricing and will be positioned to exploit the opportunity tactically.

Pankaj Pathak
The author is fund manager, Fixed Income, Quantum Mutual Fund

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