Debt Commentary – August 2016
| ||31-Aug-16 ||31-Jul-16 ||Change (bps) |
|10 Year Benchmark Yield (s.a)
|10 Year AAA (PSU) (ann)
|5 Year AAA (PSU) (ann)
|3 Month T Bill
|3 Month CD
|12 Month CD
|10 Year AAA Spread
|5 Year AAA Spread
The bond market remained bullish during the month, buoyed by various global and domestic factors. Brexit led to growing calls for more aggressive quantitative easing to support growth and also considerably dented US Fed’s efforts to continue hiking its interest rates. On the domestic front, RBI’s decision to frontload liquidity infusion in banking system buoyed sentiments. Also, the systemic liquidity surplus increased from an average level of Rs.110 billion in July to Rs. 310 billion in August. Confluence of these factors had a very positive bearing on domestic bond market sentiment with bond yields falling sharply. For the month, 10year benchmark yield eased by 6 bps. Tracking the bullish sentiments, the corporate bond yields too turned lower with spreads compressing. While the 5year AAA bond yield eased by 12 bps, the 10 Year AAA bond yield eased by around 15bps, the credit spreads compressed by 10 -20 bps. The yields on the money market instruments at the shorter end remained largely range bound. However, 1year CD space saw demand from non-mutual fund buyers and rallied by 10 bps.
In its 3rd bi-monthly monetary policy announced on 9th August, the RBI maintained a status-quo on key policy rates while retaining its accommodative policy stance and emphasizing adequate provision of liquidity. Also, the policy statement, stance and key projections remained largely unchanged from its last policy with focus on monetary transmission of past rate cuts. While the policy touched upon the recent developments such as the Brexit, accommodative policy by Japan and domestically, the 7th Pay Commission & GST, its focus remained unshaken on inflation. Unlike last policy, it expects food inflation to abate however expects this to be counterbalanced by an uptick in core inflation; particularly in the backdrop of the implementation of the 7th Pay Commission. On balance, it retained its inflation target of 5% by Mar’17 with risks on the upside.
US nonfarm payroll employment increased by 1,51,000 in August of 2016, lower than an upwardly revised 275,000 in July and below the market expectations of 1,80,000. This has decreased the expectations of a September hike in Fed funds rate.
On the macro economic data released during the period, CPI inflation rose to 6.1% y-o-y in July from 5.8% in June, above expectations, and breaching the RBI’s 4% +/- 2% target on the upside. Recent increases in the CPI have largely been driven by higher food prices, especially vegetables. Food price inflation rose sharply to 8.4% y-o-y in July (7.8% in June) and has contributed 1.3% to the rise in headline CPI inflation over the past four months. Meanwhile, the moderation in June core inflation failed to be sustained in July, rising to 4.64% from 4.55%. Looking ahead, it is likely that CPI inflation peaked in July, and should decelerate hereafter. We expect the core inflation to stay ranged under the assumption of limited upside to global petroleum product prices and lagged inflation impact of negative output gap. Also, despite the recent acceleration in Food inflation, we expect a sharper disinflation in the second half of the fiscal, premised on sharp declines in Pulses prices, helped by good rains. Pulses inflation may dip from near 27%YoY currently, towards (-) 10% implying potential disinflation of around 80bps on the headline CPI inflation.
Industrial production growth rose to 2.1% y-o-y in June from 1.1% y-o-y in May (revised down from 1.2%), above expectations. On the supply side, manufacturing output growth disappointed, staying at very weak levels (0.9% y-o-y), while the pickup in mining (4.7 % YoY) and electricity (8.3% YoY) was due to base effects. On the demand side, the capital goods sector continued to weigh on industrial production, with output contracting 16.5% y-o-y. On the consumer front, durables output growth remains steady reflecting modest urban demand. Consumer non-durables output growth returned to positive territory after contracting continuously for 11 months (exception October 2015), led by the tobacco and wearing apparel segments, perhaps indicating early signs of an improvement in rural demand. We expect industrial activity to gain traction in the last quarter of 2016, as consumer goods should benefit from pay hikes and a stronger rural economy, and capital goods should be supported by higher public capex, but weak global and private capex demand may remain a drag.
In terms of the monetary policy outlook, RBI may want to wait for credible signs of inflation deceleration as it looks for scope for additional monetary accommodation. However, space for residual easing (25 bps) may open up as inflation is still likely to fall towards the RBI’s inflation glide path target by the close of FY17. But, prospect of deeper easing is unlikely, as it requires signs of sustainable deceleration in inflation below the 5% threshold or a lower real policy rate – preconditions that seem unlikely to be fulfilled, at this stage. As far as sovereign bond yields are concerned, given the recent sharp rally, any sustainable fall is unlikely. We expect the 10 Year benchmark yield to consolidate in a broad range of 7.05%-7.25% in the near term.