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Global surplus to fuel rush of foreign money in the bond market

LiveMint logoLiveMint 10-06-2014 Ravi Krishnan

Foreign money is raining into Indian bonds. Since the beginning of May, foreign institutional investors (FIIs) have bought $5.1 billion of Indian debt compared with $3.8 billion of equities. The fundamental reasons are the same: stable government, expectations of structural economic reforms, and all this, financed by short-term liquidity sponsored by Draghi and Co.

However, bonds have a couple of additional boosters as well. For one, unlike the huge run-up in equity prices, bond yields haven’t collapsed; so, there is much more room for a bond market rally. Secondly, the global liquidity surplus situation means US short-term bond yields are low and there is a huge differential with rates in India.

Still, it must be noted that this foreign money is also a punt that the exchange rate will be stable, thus saving on hedging costs. Despite all this $8 billion inflows, the rupee has gained only 1.5% or so in this period. The central bank’s intervention has not only built forex reserves, but ironed out volatility. Dealers say most of this has happened in the forwards market. As a result, forward hedging premia still hover around 8.5%. Thus, insuring for exchange fluctuations would leave investors with no returns.

Does this mean that the rally will continue?

Graphic by Sarvesh Sharma/Mint

In the short term, the stream of foreign money coming in is going to dry up. FIIs have already invested up to 93% of their allowed limit. Unless the government hikes the limits or changes the rules, that will affect rates in the short term.

Leaving that factor aside, things are likely to move in the same direction. A stable rupee and a large negative output gap, which suggests that an economic recovery will be long-drawn, indicate that the time for interest rate hikes may be over. The latest monetary policy review suggests as much.

The liquidity situation could also change from the current deficit mode. If the central bank doesn’t sterilize its forex interventions, that could help ease short-term money market rates and improve sentiment in the bond market. Indeed, overnight money market rates have fallen below the repo rates quite a few times in the past weeks.

However, there is a fine line to be treaded here. Too much liquidity can stoke inflationary expectations.

The latest rain forecast by the weatherman is also a cause for concern as it can affect both growth and inflation. Like farmers, bond investors too should be looking to the skies.

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