Bond yields have fallen dramatically over the past few days. Thus the yield on the 10 year government bond is down almost 60 bps over the past month, and is now within shouting distance of the post demonetization lows. This has been one of the best bond performance from across the world, although directionally there is continued bond optimism in most geographies. The sharp fall here also gives rise to the obvious question: have our yields fallen too much?
No directional phase is one way consistently and one should expect some retracements from time to time. Indeed, the recent rally has been very sharp and it is possible that it gets followed up with a period of consolidation/ retracement for some time. However, there is little to doubt that the bond environment remains constructive and hence notwithstanding some potential reversals / consolidations, there seems enough reason to continue to engage with the market. We summarize some of the key aspects of the environment below:
1. The global backdrop: In the US the first phase of the bond rally was when market was leading the Fed. In other words, the market was signaling that the Fed may be headed for a mistake by not easing policy. This phase was marked by a substantial curve flattening. Now, with the Fed acknowledging ‘cross currents’ and weakness in inflation expectations, and almost explicitly signaling easing, the phase of market leading the Fed is over. With this the flattening of the curve has also reversed. This is shown in the graph below:
It is to be noted that this is a curve pattern that has been followed in previous instances of curve inversions as well. This is shown below:
As can be seen in the graph, following the episode of flattening the yield curve tends to steepen quite a bit going into the actual recession as the Fed starts to cut rates. In line with this, the next few months will be one of recalibrating the quantum of cuts depending upon incoming information where both the market and the Fed will judge whether there is actually a risk of recession developing or not. It is to be noted that there is nothing to suggest in US data per se that a recession is imminent. However, the synchronized manufacturing slowdown globally has largely continued with risks that at some juncture it starts spilling into services.
Thus the narrative with respect to the world remains one of expected monetary easing on the back of weaker growth and muted or falling inflation expectations. This is particularly true in geographies like the Eurozone where the growth – inflation mix is particularly weak.
2. Domestic growth drivers: India’s own manufacturing cycle is displaying similar strains as visible in a host of data points (auto, Purchasing Managers Index (PMI), Wholesale Price Index (WPI) prices, trade data) with an added drag from the ongoing financing squeeze, that has served to prematurely slow consumer leverage creation in an environment of already weak income growth. The Economic Survey lays out a growth model based on an investment revival where the capacity thus created will get filled by exports. However, this will involve significant market share gains given both cyclical and somewhat structural evolving limitations to world trade. In the meanwhile, growth will have to also find support from countercyclical discretionary policy. With fiscal levers limited (more of this in next point), monetary policy is the natural port of call.
3. A relatively prudent budget: The budget resisted any sort of counter-cyclical expansion, even when it was heavily prescribed by the private sector and the RBI governor himself didn’t seem very averse to it. Quite the contrary, it hiked some taxes (excise, custom, super-rich income tax) to make up for deficiencies in other taxes (GST, income tax). This obviously makes the role of monetary policy stronger for continued countercyclical response. A final source of comfort is the evolving structure of inflation where core is breaking lower. Indeed, market expectations are now between 50 to 100 bps residual of easing left in this cycle.
4. Demand versus supply: Bond yields demonstrated remarkable volatility over late 2017 to late 2018. This had significantly curbed appetite of investment books in the market. Over the past year or so, the RBI has conducted Open Market Operation (OMO) purchases of around INR 3,50,000 crores. This has had the effect of significantly reducing the size of banks’ investment books in an environment where liquidity has now turned positive as a conscious policy tool and there is some risk aversion developing in segments of lending. Bond performance has also turned significantly positive. All in all, and as deposit accretion hopefully improves on the back of improved liquidity, it is likely that banks net demand turns out to be much stronger than what has been seen in the past year.
Furthermore, the supply equation for government bonds is set to turn decisively more favorable between October to March. Assuming the talked about USD 10 billion sovereign issue goes through during this period, the following table summarizes the numbers:
As is evident from the table adjusting for the sovereign issue, net supply of government bonds drops to just about 22% of the first half net supply. On the other hand, SDL net supply is slated to rise significantly (in the table above it is assumed that balance SDL issuance till September end will happen as per calendar, second half issuance is our estimate). Similarly, PSU bond supply is also expected to pick up from second half. Reflecting this relative supply scenario, we have re-oriented our active managed duration funds towards government bonds from our earlier preference for quasis (SDL, corporate bonds).
Conclusion
The recent rally has been quite fast and dramatic. Apart from the pace of fall in yields, this is also evident in the significant relative underperformance in all but the top 2 traded government bonds. As a result, some significant pockets of value have emerged in 6 – 12 year bonds outside of the top 2 traded. Such a strong concentrated rally is naturally prone to some stagnation or reversal. However, as described above, both the macro and micro frameworks remain reasonably bond bullish and we are happy to continue to participate, although our instruments of choice may keep shifting depending upon relative value within the core interest rate buckets (AAA/SDL/sovereign). As mentioned above, preference for duration building is now via sovereign given the very benign supply environment for government bonds that is likely coming over the second half of the financial year. This may also help further compress term spreads of sovereign versus repo, which otherwise have generally been quite elevated since late 2017 owing to diminishing risk appetites and excess supply overhang.
Also while past comparisons are useful, they must be made with caution. For instance, while demonetization was a significant local development, it must be remembered that a global reflation trade had begun in earnest at the same time with expectations of a US fiscal stimulus from the Trump administration. Also, RBI had embarked in 2017 on a significant OMO sale program thereby significantly adding to gross bond supply just as post demonetization deposit accretion was beginning to fall away. Whereas, the current phase is that of a synchronized global slowdown where local fiscal policy so far has been relatively disciplined. Thus it is not necessary that ‘demonetization lows’ should actually form some sort of a lower bound to yields in the current environment.
As always, investments need to be considered in 3 buckets of liquidity, core and alpha. In our view it remains a very constructive environment to continue to allocate to AAA front end that chiefly forms part of core allocation bucket.
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