Short-term positive for INR bonds

Radhika Rao, India Economist, DBS Bank, Philip Wee, FX Strategist, DBS Bank and Eugene Leow, Rates Strategist, DBS Bank

India government bonds have retained most of last week's gains, after the authorities took steps to mitigate near-term demand-supply mismatch in the government's papers (see here). 10Y yields declined sharply to 7.3% in late-March vs 7.6% earlier in the month, with bonds opening at a firmer note this week as well. The Reserve Bank of India also surprised markets by extending support to the domestic banks, in the face of likely further pain from higher provisioning and bad debt burden this year. Banks have been allowed to spread out their trading losses faced in the December 2017 and March 2018 quarters, equally over the subsequent four quarters. By way of a caveat, banks have been asked to create a 2% Investment Fluctuation Reserve (IFR).

Bonds are likely to trade with a positive bias in the short-term, in view of few other catalysts: a) today's RBI rate decision, where softer inflation in the March quarter (40-50bps miss vs RBI's forecasts) lower the need for the RBI to tighten rates in haste. Tone will be balanced, similar to February, with an eye on minimum support price increases, high domestic fuel prices, impact on inflationary expectations and global uncertainties (heightened trade war concerns); b) imminent roll out of the new FPI (Foreign Portfolio Investors) framework, which is expected to augment demand for the bonds; c) softer UST yields.

INR liquidity is in small surplus and is likely to remain so in April, in light of upcoming redemptions. 10Y Yields are likely to hover in the 7.2-7.4% range in the near-term but conditions are unlikely to be as supportive as we head into H2. Notably, a slower start in H1 borrowings is likely to turn the supply pipeline busier in H2, just as the fiscal run-rate routinely turns adverse and state borrowings also hit the markets.

For the near-term, we prefer to take advantage of this rally to scale out of longer-tenor bonds. While bonds can rally a bit more, we are cautious on the longer-term outlook. The 2Y/10Y spread has narrowed to 50bps, not quite sufficient pickup to entice investors to take on duration risks. Meanwhile, our call for the front of the INR curve to do well has played out (see here). With liquidity conditions easing somewhat and the market paring back on RBI hike expectations, 2Y yields are now down by 50bps (6.75% currently) over the past month. At current levels, we are neutral on 2Y bonds. On a relative basis, we think shorter-term bonds should still hold up better than longer-term ones.

The Indian rupee is paying more attention to external developments. Despite a mildly hawkish US rate outlook and an escalation in US-China trade tensions, the rupee has been stable in a (0.6%-wide) 64.8-65.2 range since early March. This was consistent with the consolidation in global exchange rates since the start of global stock market volatility in February. Even so, there is one difference. Unlike last year, the rupee started the year 2018 by falling (and not rising) with Indian equities. The cyclical export recovery that buoyed Asian markets in 2017 is now challenged by US-China trade spat. We remain mindful that the rupee remains one of the three worst performing Asian currencies this year. Like the Philippine peso and Indonesian rupiah, the rupee faces downside risks from rising US rates come because of the deficits in both its current account and fiscal balances. Hence, we have not changed our mind for the rupee to depreciate to 67 by year-end.

Source : Equity Bulls

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