The Month of March was favourable for global bond markets. Indian Government bonds and Corporate bonds rallied during the month of March. Federal Reserve open market committee hiked the Fed Fund Rates in March as per expected lines. The Fed Fund Rate now stands at 0.75 to 1 % levels. However, the press statements from the Chairperson Janet Yellen which followed the hike was dovish. Fed Chairperson indicated it would stay with its predetermined path of hiking rates 3 times in the current calendar year and 3 times next year, even if CPI inflation overshoots its 2% target in the coming months. Fed chairperson stated they would tolerate CPI inflation above 2% levels and not increase the pace of rates view as CPI inflation has undershoot its target over an extended period. These comments are dovish which led to the 10 year US yields trading in the band of 2.31% -2.50% during the month of March. The dollar index was sold due to dovish comment and the US president not able to repeal Obamacare insurance. Minutes of the Federal Reserve indicates the FOMC resolve to reduce its USD 4.5 trillion balance sheet from the later part of 2017 in a gradual manner. This development is long term positive for the dollar.
Indian Government ten year yields moved down from 6.77% to 6.65% during this month of March. FII flows of Rs 25,355 crores into debt market and year end buying by nationalized banks led to yields falling by 10 to 12 basis points across the yield curve. Most of the traders, mutual funds and insurance companies have significantly reduce their positions when RBI has indicated its change in stance from accommodative to neutral. Liquidity in the Overnight markets have increased as RBI allowed the Cash Management Bills (CMB) to mature and did not roll over the CMB. Mutual funds and insurance companies don’t have access to RBI reverse repo window. Due to excess liquidity with these players, lending rates in the overnight markets came down to the Reverse repo rates of 5.75%. Most of these Investors bought high yielding illiquid Central and State government papers as liquidity is expected to be easy for the current financial year. The peak system liquidity of Rs. 8 trillion has now reduced to Rs 4 trillion but this would increase due to government spending. Mutual funds and traders purchased in the short end of the yield curve in the corporate bond to deploy the surplus cash.
The total borrowing for first half of this financial year is Rs 3,72,000 crores and predominantly concentrated in the 10 to 14year segment which should see supply of 45% of the total borrowing in the first half of the year. The government has also announced around Rs 75,000 crores of state loan auction in the first half of this financial year. This should put pressure on the 10 year and above segment and should led to investors asking for higher yields in a rising interest rate environment.
RBI in its first monetary policy hiked the reverse repo rate to 6% and reduce the Marginal Standing Facility to 6.5%. RBI has projected GVA growth for the current financial year to be at 7.4%. RBI also indicated its resolve to reduce the system liquidity through reverse repo auctions, Open Market Sales and through issue of CMB. However, it would be using Open Market Sales to neutralize its forex purchases in a non-disruptive manner and would be using reverse repo and CMB for draining out excess liquidity created out of demonitisation. RBI reiterated its stance of bringing CPI inflation to 4% in the medium term and it expects CPI inflation to be 4% - 4.5% in the first half and 4.5%- 5% in the second half of the current financial year. RBI stated the risk to its CPI inflation forecast is balanced. Inflation pressure is expected to be present due to hike in allowance of government employees, higher rural demand due to bumper harvest, rapid remonitisation of the economy, the possibility of EL Nino and its effect on food grain production and higher commodity prices. The mitigating factors are the record food grain production of 272 million tonnes and higher procurement of food grains by central government agencies. Oil prices are expected to well contained due to higher production of shale oil in US.
We expect 10year government bond to be in a range of 6.70% - 7.10 % in the current financial year due to excess liquidity prevailing in the system. System Liquidity is expected to be comfortable for this financial year and it will take 4 quarters for the system liquidity to come to neutral as per RBI Deputy Governor Viral Acharya. Banks credit growth is 3.7% in FY16-17. For the current year, credit growth is expected to predominantly come from consumption demand and not from investment demand as capacity utilization rates in the Indian economy is still around 75% levels. This will make Banks buy more government securities to deploy their accretion to deposits in the absence of credit growth. Banks along with insurance companies are expected to be large buyers of government securities during the current financial year. FII participation in the bond market should support bond yields particularly in the less than 10year segment.
The spread between government bonds and state government papers are expected to remain in the band of 80 to 100 basis points due to supply of state government papers of Rs 3.4 trillion during the current financial year. However, corporate bonds yield in the AAA rated category should be in the range of 60 to 80 basis points due to adequate liquidity in the system.