Radhika Rao, India Economist, DBS Bank and Eugene Leow, Rates Strategist, DBS Bank
Selling pressure in India government bonds have ebbed somewhat with yields pulling back modestly from two-year highs. Near-term movements in the 10Y yields are likely to be restricted to 7.5-7.7%, but are poised to head north towards 7.9% as the new fiscal year unfolds.
A handful of factors provide short-term relief; first up, February's CPI inflation, which eased to 4.4% YoY, decelerating for a second consecutive month from December's 5.2% YoY. Food prices pulled back, coupled with stable crude prices, which alongside a fading impact of the housing allowance and GST have calmed the headline CPI prints. With inflation undershooting the central bank's projected 5.1% average for the March 2018 quarter, pressure to shift the policy stance to hawkish will be lower at the April policy meeting. Global oil prices have also take a step back from threatening levels, though are still up ~20% vs same time last year.
Second, tight onshore liquidity conditions had previously aggravated the squeeze in the 10Y yields. In a bid to ease end-quarter/ end-fiscal liquidity shortage (Apr-Mar fiscal year), the RBI announced plans to inject INR 250bn into the banking system, via a variable repo auction every week, this month. This should provide room for banks to defer plans to raise their lending/ deposit rates in the near-term and keep a lid on short-term yields.
Finally, 10Y US Treasury yields have also been rangebound, not breaching 2.90% despite blockbuster payrolls on last Friday. Even if US CPI beats consensus (data due tonight), 3% would be a tough technical hurdle to clear in the short term. Moreover, we are increasingly wary of one-sided positioning in USTs. With UST positions still heavily net short across all tenors, yields may be vulnerable to the downside if economic data disappoints. Overnight, the bid-to-cover ratio for the 10Y auction also improved to 2.50 (from 2.34 previously) suggesting that higher yields may be drawing in buyers.
Overall, these improved conditions have nudged 10Y India yields off highs, but we suspect that the rally in bonds may not have much further to go. With appetite subdued from domestic (particularly public-sector banks) and foreign players (further increases in debt limits appear unlikely), 10Y yields are likely to find some support at 7.5%. We maintain that yields are likely to edge higher in the new fiscal year - when the centre's borrowing plans become clearer and fiscal costs get factored in.