Monthly Fixed Income Outlook - Nov 2023

The Indian bond markets witnessed a series of negative events after the cheer around India’s inclusion in the global bond index in the month of September 2023. RBI’s mention of OMO sale (open market operation to sell bonds and take out liquidity from banking system) to manage liquidity, spreading narrative of higher for longer interest rates in the US and an armed conflict in West Asia kept bond investors on sidelines and pushed yields higher in the month.

India bond yields moved up by 10-15 basis points across the maturity curve. The 10-year benchmark government bond yield (7.18% GS 2033) moved up from 7.22% levels end of September to the highs of 7.38%, ending the month of October at 7.36% levels.

Money market rates also surged higher with the 3 months Treasury bill trading around 6.86% in September to 6.94% at the end of October.  Yield spreads on AAA PSU debt papers over similar maturity T-bills widen by 5-10 basis points during the months to around 25-30 basis points.

Tight liquidity pushed OMO sales

In the monetary policy meeting at start of the month, the RBI held policy rates unchanged and maintained its stance of ‘withdrawal of accommodation’ in line with the market expectation. The unexpected part in the RBI governors’ statement was the one about conducting OMO sale to manage excess liquidity – RBI selling bonds to suck out excess liquidity from banking system.  

The announcement came at a time when the banking system liquidity was is deficit. In this regard, the RBI clarified by referring to the measure of liquidity (core liquidity) which includes the cash balance with the government as it will make its way into the banking system as the government picks up spending.

Since the announcement, the core liquidity has only increased from surplus of Rs. 2.9 trillion to Rs. 3.3 trillion. Yet the RBI has not announced any OMO sale till date. One of the reasons could be the fact that the liquidity in the banking system remained in deficit for this entire period while government cash balances continued to increase. This indicates that the RBI is not willing to tighten the banking system liquidity too much though they are worried about high core liquidity surplus.

In our estimate liquidity will turn in a minor surplus in November due to expected pickup in government spending and large bond maturities during the month. While a part of the liquidity inflows might get offset by the RBI’s continued forex sale and increased cash withdrawals (increase in currency in circulation) during the festive season.

If liquidity condition eases as expected, the RBI might conduct few OMO sale auctions during November and December. However, we expect the total quantum of OMO sale to be limited to Rs. 300-500 billion only as we expect liquidity condition to tighten again during early next year due to seasonal pick up in currency in circulation.    

Geopolitical risks and crude oil prices:

Supply cut by the Saudi Arabia and Russia led oil producers’ cartel OPEC+ and conflict in middle east pushed oil prices higher at start of the month with brent crude price touching peak of ~USD 95/barrel. Later in the month, crude oil prices come down due to weak Chinese economic data and rising US oil inventories. At the month end the brent crude oil price was back to it’s September level of around USD 85/barrel.

The ongoing conflict in the middle east appears to be contained for now. But it has raised fears that exports from major crude producers may get disrupted which can push crude oil prices higher.

Given the upcoming election season, we do not expect higher crude oil prices translating into increase in domestic fuel prices in near future. Domestic fuel prices have not changed for more than a year now. However, sustained rise in global crude oil prices might weaken the investor sentiment in the bond market.

Global Interest rate risk

The 10-year US treasury yields moved up to end the month at 4.85% levels against 4.6% in September, after touching a high of 5.01% during the month.

Most of the movement was on account of inflation risk, increased US Treasury debt issuances and robust economic data impacting the expectations around the Federal Reserve to keep rates higher for a longer period. 

While the announcement of a possible OMO sale by the RBI, soaring crude oil prices and rising global interest rates added an upward pressure on yields in the domestic bond market, the yields did seek some comfort from other domestic factors like lower CPI inflation, cooling core inflation and stable demand-supply dynamics in the bond market. 

CPI inflation moving closer to RBI’s 4% target:

CPI inflation eased to a 3-month low of 5% y-o-y in September against 6.8% y-o-y in August. Moderation was largely on account of a sharp correction in vegetable prices and lower LPG prices. However, Core inflation fell to the lowest in 3.5 years at 4.6% which is a positive.

Weather related disruptions and delayed crop cycle likely to pose an upside risk to food inflation in the months ahead. While fall in core inflation to provide some respite to the RBI to maintain a prolonged pause in repo rates. Overall, we expect inflation pressure to ease going forward with CPI falling below 5% by early next year.     

Fiscal comfort

On the fiscal side, gross tax collection in the H1 FY24 has grown by 16.3% over same period last year. This is significantly higher than the full year budget target growth of 10.4%. Non-tax revenues have also shown a remarkable growth compared to budget estimates owing to the large dividend of Rs. 874 billion from the RBI. Other public sector companies are also expected to deliver higher dividends to the government than the budget estimate in light of sharp jump in profits.

In our estimate, combination of tax and non-tax collections could provide government around Rs. 1.5 trillion extra revenues than their budget estimates. Even after adjusting for some shortfall in the disinvestment target, the government will likely have more than Rs. 1.2 trillion of extra cash this year. This can be used to reduce taxes on fuel or increasing welfare spending without stretching the government’s fiscal position. This also opens a possibility of a reduction in government borrowing later in the year which is also supported by a strong trend in collections under small saving schemes which has grown by 30% yoy in H1FY24.

At the same time, we expect demand to remain firm supported by healthy growth in AUMs of PFs, pensions and insurance companies and expected foreign demand due to India’s inclusion in the JP Morgan Government Bond Index – Emerging Market (GBI-EM Index) .   

Outlook

Given the sharp jump in bond yields since start of the month, much of the near-term negatives are already priced. Risk of geopolitical conflict intensifying – pushing commodity prices higher, will continue to keep investors on sidelines in near term.

While from a medium-term perspective, outlook for bonds looks favorable supported by peaked policy rates, falling inflation trend, and favorable demand supply mix.

At current yield levels, valuation also look reasonable for medium to long duration bonds. The 10-year government bond is currently trading at 80 basis points above the policy repo rate. Given the policy repo rate is near cycle peak, this spread looks high compared to its historical average during peak rate environment.

In line with this view, we would use every rise in yield to extend the portfolio duration by accumulating long term bonds in a staggered manner.

Investors with 2-3 years investment horizon and some appetite for intermittent volatility, can continue to hold or add into dynamic bond funds.

Dynamic bond funds have flexibility to change the portfolio positioning as per the evolving market conditions. This makes dynamic bond funds better suited for the long-term investors in this volatile macro environment.

Investors with a short-term investment horizon and with little desire to take risks, can invest in liquid funds which invest in government securities and do not invest in private sector companies which carry lower liquidity and higher risk of capital loss in case of default.

Source: RBI