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Which way are debt markets facing?

LiveMint logoLiveMint 06-06-2014 Lakshmi Iyer

The 10-year government securities (G-sec) have seen bouts of volatility between November 2013 and April 2014. In the May-September 2013 period, fears of quantitative easing (QE3) in the US prompted a pullout by foreign institutional investor (FII) from the Indian debt market. This caused a huge sell-off in the debt market and a sharp decline in the rupee against the dollar. To protect rupee’s value, the Reserve Bank of India (RBI) curtailed liquidity borrowing and made overnight borrowings expensive. This caused the unseemly situation where the 10-year G-sec was pushed into the 9% territory; and the money market rates above the 10% mark.

However, after the QE3 tapering fears subsided in September 2013, the regulator normalized the market situation by easing the liquidity restrictions and reducing borrowing costs.

After the monetary policy and market yields normalized, the central banker adopted a more traditional role of inflation and growth management. Herein, RBI took a relatively hawkish stance vis-a-vis the rising inflation in the Wholesale Price Index (WPI). In the June-November period, WPI had risen from 5.16% year-on-year (y-o-y) to 7.52% y-o-y. This rise in wholesale prices was attributable to rapid increase in prices of fruits and vegetables on account of supply paucity. For this reason, the central banker, while reducing the operational liquidity rate (marginal standing facility), increased the repo rate in three tranches of 25 basis points each in September 2013, October 2013 and January 2014. Thus, the repo rate rose from 7.25% in September to 8% by January-end. Yet, there was latent optimism in the market since the WPI-inflation was expected to moderate swiftly (WPI came down to 5.17% in January 2014) due to improving supply conditions.

Having said that, the 10-year G-sec began to inch up from January 2014 on account of change in the policy calculus. RBI, based on the recommendations of a panel led by its deputy governor, decided to base its policy decisions on Consumer Price Index (CPI) rather than WPI. Historically, there has been significant lag and divergence between CPI and WPI, mostly on account of the fact that price sensitive items such as food and energy have higher weightage in CPI than in WPI. Thus, this shift in the inflation benchmark implied extended period of hawkish stance by RBI.

However, the 10-year G-sec stabilized around mid-February on account of a more benign budgetary data. This provisional budget pegged the fiscal deficit for FY14 at 4.6% and projected the FY15 fiscal deficit at 4.1%. However, since the change in the central government, a more robust and clearer budgetary picture is expected to materialize (by June-July) but the supply outlook is still not entirely clear.

By March-April 2014, the market began to factor in the possibility of change in the 10-year benchmark G-sec. Due to this, the appetite for 10-year G-sec declined, and market yields increased. Moreover, the expectation of a change in the government post the elections also made the market more circumspect about the evolving business environment.

During this period, the external trade account of the Indian economy improved leading to decline in the trade and current account deficit (CAD). Moreover, the expectation of a pro-growth mandate in the general election also pushed up FII inflows into the economy. As a consequence, the rupee appreciated against the dollar during this period—by around 3.36% between 27 November 2013 and 30 April 2014; and by around 6.74% from November 2013 till mid-May 2014.

Market outlook for next 6 months

The following factors are likely to drive the markets:

• Stable government: The recently concluded general elections have given a clear mandate for a stable government. This was the first and the most important requisite for a bull market and it has been delivered. We expect that the new government will address the inflation issue and ensure that the economy is back on the growth path. In turn, this will help RBI give monetary policy support to growth.

• Inflation: The trajectory of CPI is southwards. In case there is an adverse monsoon, the government has sufficient buffer food stock to ensure supply. So, inflation is not a problem.

• Liquidity: The CPI-inflation trajectory is downward and economy is likely to turn around. It is expected that iron ore exports may increase and the coal imports may decline. This is likely to have a positive effect on trade and CAD, which is likely to be 2.00-2.30% of the gross domestic product. The rupee is headed towards the 56 mark. But since RBI is purchasing dollar, this rally is contained at 58. A sharp depreciation over the next six months is ruled out. The broad trading band for the rupee is likely be around 55-60 for the year. If the inflation trajectory is as per RBI’s expectations, the dollar flows (FII and foreign direct investment) in the economy are likely to pick up. In this case, RBI is likely to support with easy liquidity.

One more important factor is the budget, which is the next important event now that the monetary policy review is out. RBI, before taking any action, would like to see credible budget curbs on fiscal deficit. This will be a very big factor and the government is expected to deliver on the same.

Thus, if the above factors are in line, then there is a case for a rally of 30 basis points shift in the curve, at the very least. However, volatility in the interim cannot be ruled out due to over-discounting or euphoria before the budget.

Lakshmi Iyer is chief investment officer (debt) and head-products, Kotak Mutual Fund.

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