Fixed
Income Monthly View – Sept 2022
Indian
bond yields have been falling (bond prices rising) since mid-June 2022. The
10-year government bond yield peaked at 7.6% in June. It fell to 7.45% by June
end, 7.32% by July end, 7.24% by August end, and at the time of writing on
September 8, 2022, it is trading around 7.08%.
The
decline in bond yields started with a clamour of global growth slowdown and
falling commodity prices. An expectation of India’s inclusion in the global
bond index also added to the positive market sentiment.
Crude
oil has come down sharply over the past two months on fears of a global
economic slowdown reducing oil demand. The brent crude oil price fell from ~USD
112/barrel at the June end to ~USD 89/barrel on September 8, 2022.
The
decline in commodity prices eased some of the concerns about inflation. The CPI
inflation eased to 6.71% in July 2022 vs over 7% inflation during April – June
2022 period. Sequential month-over-month inflation has been easing across many
components of inflation suggesting the producers have slowed down the pace of
price increases.
Assuming
no further inflationary shock, CPI inflation for the 12 months forward period
should average around 6%. The RBI may draw comfort from inflation coming down
to 6% or below in the near term while taking a more medium-term view to achieving
the 4% inflation goal.
This
would allow the RBI to slow down the pace of rate hikes going forward. We
expect the RBI will hike the repo rate by another 25 basis points in the upcoming
MPC (monetary policy committee) meeting to be held at end of September. We
maintain our call of repo rate peaking around 6% by end of this year or early
2023.
During
the last month, liquidity surplus in the banking system came down below Rs. 1
trillion owing to heavier than usual cash withdrawals from banks during August,
RBI’s selling of foreign exchange (which in turn takes away INR from the
banking system), and build-up of government cash balance during the month.
The
core liquidity surplus which excludes the government’s surplus cash balances
and is considered a more durable source of liquidity has also been coming down
rapidly for the last six months. The core liquidity surplus was around Rs. 9
trillion in March 2022, it fell to ~Rs. 6 trillion by June 2022, and, in August
core liquidity is slightly above Rs. 4 trillion.
With
the early arrival of the festival season, we expect cash demand to increase
further in the September to December period. The RBI may also have to sell
foreign exchange to fill the gap in the balance of payments. This, along with
the double-digit credit growth will further reduce the core liquidity
surplus.
Core
liquidity surplus may fall below Rs. 2 trillion by October 2022. Assuming a
running government balance of around Rs. 1-2 trillion, banking system liquidity
will become neutral to the deficit during Q4 of 2022.
Given
the economic growth is still below potential, RBI might want to keep the
banking system liquidity in surplus of around 1% of NDTL. Thus, there is a
reasonable possibility of RBI adding liquidity through OMO purchases of
government bonds in Q4 2022 and Q1 2023. If this happens, this should be
supportive of the demand-supply dynamics in the bond markets.
Although
the domestic environment has improved, the external environment has turned more
hostile to the Indian bond markets.
The
10-year US treasury yield has moved up during the month from a bottom of around
2.6% to ~3.3%. At the Jackson hole symposium, the US Fed Chairman Jerome Powell
delivered a hawkish speech suggesting rate hikes will continue and higher rates
will be maintained for long period.
Powell’s
speech was a big pushback to the part of the market which was pricing for a
rate cut by the Fed on the first sign of economic weakness. Market expectations of terminal US Fed Fund
rate moved up to 4% vs 3.5% a fortnight back.
Similar
hawkishness can be seen in the commentary from other central banks in that part
of the world including the European Central Bank, Bank of Canada, and Bank of
England. All are hiking their respective policy rates at a pace of 50-75 basis
points every meeting.
This is
not a conducive environment for foreign investors to invest in emerging
economies. Thus, we do not expect large inflows from foreign investors
immediately even if India gets inducted into the global bond indices though it
would be sentiment positive for the domestic investors and might extend the
bond rally for some more time.
Going
ahead, the bond market should continue to track the movement in crude oil
prices and the domestic demand-supply balance.
We
expect the 10-year government bond yield to continue to trade in a broader
range of 7.1%-7.5%. The short end of the curve will likely move higher with
Overnight rates moving closer to 6% by the year-end.
Considering
the duration-accrual balance, the 3-5 year segment remains the best play as
core portfolio allocation. The long end of the yield curve is vulnerable to an adverse
demand supply shock. However, any mispricing in this segment can be exploited
through tactical positioning from time to time.
We
suggest investors with a 2-3 years holding period should consider adding their
allocation to dynamic bond funds to benefit from higher yields on medium to long-term
bonds.
Dynamic
bond funds have the flexibility to change the portfolio positioning as per the
evolving market conditions. This makes dynamic bond funds better suited for
long-term investors in this volatile macro environment.
Investors
with shorter investment horizons and low-risk appetites should stick with
liquid funds. With an increase in short-term interest rates, we should expect
further improvement in potential returns from investments in liquid going
forward.
Since
the interest rate on bank saving accounts are not likely to increase quickly
while the returns from the liquid fund are already seeing an increase,
investing in liquid funds looks more attractive for your surplus funds.
Investors
with a short-term investment horizon and with little desire to take risks
should invest in liquid funds which own government securities and do not invest
in private sector companies which carry lower liquidity and higher risk of
capital loss in case of default.
Disclaimer, Statutory Details & Risk Factors:
The views expressed here in this article / video
are for general information and reading purpose only and do not constitute any
guidelines and recommendations on any course of action to be followed by the
reader. Quantum AMC / Quantum Mutual Fund is not guaranteeing / offering /
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views are not meant to serve as a professional guide / investment advice /
intended to be an offer or solicitation for the purchase or sale of any financial
product or instrument or mutual fund units for the reader. The article has been
prepared on the basis of publicly available information, internally developed
data and other sources believed to be reliable. Whilst no action has been
solicited based upon the information provided herein, due care has been taken
to ensure that the facts are accurate and views given are fair and reasonable
as on date. Readers of this article should rely on information/data arising out
of their own investigations and advised to seek independent professional advice
and arrive at an informed decision before making any investments.
Risk Factors: Mutual Fund investments
are subject to market risks, read all scheme related documents carefully.
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