Indian bonds have had a very good run over the past few months with RBI’s proactive liquidity infusion playing a big part alongside a backdrop of a conducive macro-economic environment. With market consensus now pricing a terminal repo rate of 5.5%, there is discussion emerging on how much more can the bond market offer. One way this doubt is getting expressed already is in recent significant rise in term premia. Thus, the market is now demanding higher compensation for perceived uncertainty for holding longer maturities at lower levels of yields. We dig a little deeper below on some of these dynamics.
The point about sustainability of lower yields, which is fundamentally linked to the rising compensation desired for holding more duration, can be best assessed with a quick evaluation of the underlying macro setup. Before we do that, however, a clarification is in order: Some amount of steepening in a rate cut cycle is perfectly normal and the idea here isn’t to find reasons to push against that. Rather, the point we are after, which is much more important for ‘real money’ investors, is this: can the steepening process unfold in a way that it negates most of the duration advantage offered by holding longer term bonds? Or put another way with more nuance, is the risk adjusted return offered better at lower duration points even for real money investors? That is, are there significant tail risks emerging that may make pursuit of returns by assuming higher duration quite counter-productive even though the plain math will always obviously support longer duration exposures in a falling rate environment? This point also can be best clarified by assessing the underlying macro-setup, which we turn to next.
Macros Are Supportive
There are 3 aspects to the current macro set up that are decidedly bond bullish:
1. The dollar is retreating even as US rates and Fed rate cut pricing remain volatile. This is largely to do with years of overweight financial allocations to the US under the so-called US exceptionalism theme, which is now partly diversifying. We have done deep dives into this before and will refrain from doing so here, but to make two observations: One, this was a long period phase of the exceptionalism theme allocations and hence the diversification out phase may also play out over-time, thereby possibly posing a more sustained drag on the dollar. Needless, to say this won’t play out in a straight-line and will be subject to volatility. Two, this trend shouldn’t be confused with the dollar losing reserve currency status. Thus, one can very well have a phase of global investors diversifying out somewhat from the very overweight dollar asset positions put on over the past few years, alongside dollar retaining its preferred reserve currency status. Put another way, the ‘financial’ dollar is far stronger than the ‘trade-weighted’ dollar and there is room for this to compress without converging.
Even with the above dynamic being in place, however, global bond investors will need some handle on US rates before actively looking for duration elsewhere. While US fiscal dynamics remain concerning, with the bill currently under passage offering no solace, we are looking for US bond yields to eventually break lower. The ‘final’ level of US tariffs may be much more benign than what was feared only weeks ago but there will nevertheless be drags on growth from two avenues: One, average tariffs will still likely be 4 or 5 times what they were before. Two, the channel of uncertainty will be large and enduring and may tell on investment and consumption plans of economic agents for many quarters to come. Also, this will be happening against a backdrop where some of the other growth drivers were already beginning to tire out. Thus, it is possible that ‘hard data’ out of the US starts to weaken in the months ahead. It is to be noted that the 100 bps odd Fed rate cuts ahead as per market pricing is an average expectation containing some tail probabilities on both sides. Thus, it is likely that, should the pace of data deterioration picks up, market pricing of rate cuts also changes markedly with consequent downward impact on yields. It is also to be noted that the remarkable resilience of the US economy over the past couple of years may be telling on analyst forecasts currently. That is, since the economy held up in the face of rapid Fed tightening and periodic sentiment declines, there is more reluctance now to call any sort of an inflexion point on growth for fear of being wrong again. Note, this is offered only as observation and not criticism, towards establishing the point that the probability of markets walking into an economic tail risk may be being underappreciated at the moment given this context.
2. RBI has turned pro-active on monetary policy with focus on efficacy of transmission. It may be recalled that in the first phase of this year the central bank was focused on unwinding the unintended liquidity tightening consequent to the dollar sales undertaken over the last part of 2024. Over the past few months, however, the focus now is squarely on ensuring enough system liquidity to facilitate broad-based transmission of the rate cuts being undertaken. One of the main tools for liquidity infusion have been bond purchases which has created replacement demand for bonds in the market. Part of the ‘distrust’ on market levels may be emanating from precisely this: that the short period change in terminal repo expectations combined with INR 5 lakh crore plus of RBI OMO purchases since January, may have created an artificially benign environment that may start unwinding in the months ahead. However, the counterpoint there is that market may yet become comfortable that the lower repo rate is here to stay for the foreseeable future. India’s inflation trajectory looks exceptionally benign for the next many months and FPI’s may yet find favor back for Indian bonds if they expect dollar to continue depreciating and US yields break lower. Thus, it is quite likely that as the market ‘acclimatizes’ to lower repo rate and finds that it is not very short lived owing also to a more benign global environment, the steep curve starts encouraging more duration demand.
3. The government has shown time and again that it is fiscally responsible and has delivered on a path of fiscal consolidation. Furthermore, the path shown ahead looks credible since it doesn’t rely on incremental ‘over-delivery’. Thus, there is very little tail risk of any sort of conscious fiscal aggression getting undertaken that may damage duration bonds. From a macro-policy standpoint, one can argue that one of the reasons monetary policy has turned more active is precisely because of the understanding that fiscal policy needs to be run more conservatively given the long term credibility that this will build. While this combination should invite a steeper yield curve as has been the case so far, it also implies that investors cannot be agnostic to longer maturity bonds. To state the obvious, this is a very different situation than in the US where long duration bonds are facing pressure owing to a loose fiscal stance.
Valuations Are Still Comfortable
We have discussed above why investors needn’t be very suspicious of the sustainability of lower rates. In other words, while some amount of steepening is logical with falling policy rates and easier liquidity, the component of additional term premium demanded linked to the question of how long can lower rates last may be capped. We next turn to the valuation question: are bond yields low enough that investors no longer see any meaningful gains from duration even when pricing in some sustainability to lower repo rates?
We present below two charts that demonstrate the quantum of steepening that has happened over a relatively short period of time. The first of these tracks how spread between the 10 year and 5 year government bonds have moved. The second one does the same between 30 year and 10 year.
As can be seen, term spreads are now at a 3 year high. While the period immediately after the pandemic had seen even higher spreads it may be remembered that fiscal deficit had doubled between FY20 and FY21 and has since been brought down progressively. Also, the current deficit of 4.4% has also subsumed a significant chunk of below the line items which weren’t earlier part of the headline deficit but were very much requiring financing. Thus, while the short period rapid expansion in term spreads we have experienced over the past few months is quite understandable and is owed to a sharp change in RBI’s reaction function alongside terminal repo rate expectations falling further, it is probably too soon in our view to question the sustainability of the fall in yields. This should cap the extent of steepening and keep the duration advantage on performance alive, even though this hasn’t been all that apparent in recent months.
Another way to assess relative value is to assess spreads available on various proxies versus various points on the underlying government bond curve. SDLs across most tenors are 30 – 40 bps over underlying government bonds of the same tenor. However, at the long end, SDL spread is hardly anything over underlying government bonds. The dynamic is similar for zero coupon government bonds (constructed by stripping out coupon bearing bonds). Finally, if one adds the spreads as shown in the two charts above one can see the spread between 30 year and 5 years is almost 90 bps. Given, as discussed above, this doesn’t represent any change in the fiscal situation it is a remarkable development indeed. Not that we expect it to happen, but if the government / RBI were proactively monitoring term spreads this was reason enough to adjust the composition of the auction calendar. Given the pains we have taken to ensure stable macro-policies, and the optimism with which we are looking towards the future, it does seem very counter-intuitive that the 15 year government bond 15 years from now is being priced approximately 85 bps higher than the current 15 year as per the yield curve today! Like we said, while we don’t expect much to be done from a supply standpoint, there is evidence from the market that this yawning yield gap is beginning to strengthen demand for the long end of the curve.
Conclusion
The recent yield curve steepening is understandable to the extent it represents a rate cutting cycle and a proactive liquidity stance. However, insofar as it also has an uncertainty premium linked to the sustainability of lower rates, we think there is scope for this to stabilize. This is so long as the current macro setup in play as described above holds. More specifically, while the bond market’s incremental benefits from RBI’s proactive easing may start diminishing at some point, the benefits from a phase of weaker dollar buoying demand for Indian assets alongside fiscal credibility both reaffirming India’s attractiveness and keeping a lid on total bond supply may be more enduring. Also, while the scope of RBI’s easing may peak off soon, the central bank may still keep financial conditions at that level for a long time given the global uncertainty on growth and benign local inflation dynamics. For these reasons, we think the market may soon be comfortable that the likelihood of any imminent reversal is low, and there are gains yet to be made from duration. Again, this is not to imply that gains will be in a straight line, thereby requiring the requisite risk appetite and investment horizon for any duration play.
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