Bond yields moved up in
February due to hawkish RBI commentary, higher than expected inflation print,
and a sharp jump in the US treasury yield. Tightness in the money markets ahead
of the financial year closing also dampened the market sentiment.
The 10-year Indian
government bond (Gsec) yield rose 11 basis points (1%=100 basis points) in
February to close at 7.46% on February 28, 2023. The Gsec yield curve flattened
as the front-end yields jumped higher than longer-tenor bond yields. The 1-year
Gsec yield moved up 53 basis points from 6.77% to 7.30%. The gap between the 10-year
and 1-year Gsec yields shrunk to 16 basis points on February 28, 2023. This
spread was around 58 basis points a month back.
Money market rates also surged
higher due to continued reduction in the core liquidity and lack of demand for short-term
papers ahead of the financial year closing. A sustained wide gap between credit
and deposit growth in the banking system also contributed to a rise in short-term
interest rates.
The 3 months treasury bill
yield moved up from 6.48% on January 31, 2023, to 6.91% by February 28, 2023.
While the yield on 3 months maturity Certificate of deposits (CD)/commercial
papers (CPs) of AAA-rated PSUs jumped from 7.15% to 7.50%.
Banking system liquidity
remained in deficit for the most part in February. The core liquidity which
excludes the government balance continued to decline due to seasonal increases
in cash withdrawals and the RBI’s forex sale. The core liquidity is still in
surplus of around Rs. 1.6 trillion (as of February 24, 2023).
Based on historical trends,
currency in circulation may increase further till June. Thus, there is a high
possibility of further tightening of liquidity conditions in the coming
months.
The Consumer Price inflation
rose to 6.5% YoY in January 2023 vs 5.72% in the previous month. The
actual CPI number was significantly higher than the market consensus estimate
of 5.9%. A large part of the upside
surprise was contributed by an abnormally high MoM jump in cereals &
products and a lesser than expected seasonal drop in vegetable prices. Core
Inflation remained elevated at 6.1%.
Going forward inflation is
expected to trend down on a favourable base effect, stabilising commodity
prices and declining pricing power due to slow demand recovery. We expect
headline CPI inflation to fall to around 5% mid of this year and average around
5.3% in FY24.
Given
a sharp jump in headline CPI inflation, the bond market is now pricing for
another 25 basis points of a rate hike by the RBI in the April MPC meeting.
In
the last 10 months, the repo rate has been hiked by cumulative 250 basis points
and the short-term money market rates have moved up by over 300 basis points.
The full impact of these measures is yet to be seen.
Based
on the RBI’s 1 year ahead inflation estimate of 5.6%, the real repo rate is
currently at 90 basis points and the real rate on a 1-year treasury bill is
around 130 basis points. In our opinion, these levels' real rates are adequate
for the current state of economic growth.
Also,
there is no evidence of inflation expectation getting unanchored as price
passthrough by producers is muted and services inflation remains benign. Thus,
we are of the opinion that further rate hikes will not be needed and if at all
comes, will be revered soon.
We
continue to expect the bond yields to come down over the medium term with
improvement in external and fiscal balances and falling inflation. In the near
term, yields may remain in a tight range with 10-year Gsec trading between
7.2%-7.5%.
Given the fact that much of the rate
hikes are already delivered and the starting yields on bonds are between 7.3%-7.5%,
bond funds are likely to perform better over the coming 2-3 years. Investors
with a 2-3 years investment horizon and some appetite for intermittent
volatility, can continue to hold or add to dynamic bond funds.
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 appetite should stick with liquid funds. Rate hike and continued reduction in durable liquidity surplus is
positive for short-term debt fund categories like the liquid fund. We would
expect further improvement in the return potential of these categories as
interest accrual on short-term debt instruments has risen meaningfully.
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.
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