DBS Economics: Indian bonds to head into range trade

Ms. Radhika Rao, India Economist, DBS Bank & Eugene Leow, Rates strategist, DBS Bank

Narrative for the Indian bonds space has turned on its head in the past fortnight. The main near-term supply-side reprieve was the central government's plan to lower its borrowing plan for the first half of this fiscal year. But some of this supply reduction has been offset by higher supply by states. The FPI framework outlines a gradual opening up in additional limits. We prefer the front of the INgov curve, which should be less vulnerable to issuance risks in 2H and increased volatility from rising US yields.

The narrative for the Indian bonds space has been turned on its head in the past fortnight. After six months of underperformance, INR 10Y bond yields have declined from a high of ~7.7% (generic quote) in early March to 7.12% this month. The main catalyst for this reversal was the authorities' efforts to mitigate near-term demand-supply mismatch. Incoming data have also helped rein in the bond bears. These factors have triggered a rally in domestic bonds, though we expect yields to settle into a range soon.

Lower supply from the centre and higher from the states; increase in foreign investment limits to be gradual

The main near-term supply-side reprieve was the central government's plan to lower its borrowing plan for the first half (April to September 2018) of this fiscal year. The borrowing size was scaled back to INR2.88tn, 22% lower than 1H FY18's (for more details, see here). But some of this supply reduction in the June quarter has been offset by higher supply by states. States' borrowings have been front-loaded to INR1.15-1.28trn in the June 2018 quarter, compared to INR0.67-0.78trn in the comparative period last year.

Demand for bonds were expected to get a hand from higher limits for foreign portfolio investors (FPIs). The new framework, however, outlined a very gradual opening up in additional limits. Key changes included - a) Limits for GSecs (government securities) will be increased to 0.5% each year to 5.5% of outstanding stock of securities in FY19 and 6% in FY20 (in US dollar terms, the limit will rise by USD9bn over FY19); b) limit for State Development Loans (SDLs) to stay unchanged at 2% of outstanding stock of securities; c) a single limit for corporate bonds has been fixed at 9% of outstanding stock, with existing sub-categories discontinued (see table below). A measured hike in the investment limit coupled with uncertainty over the appetite of FPIs due to continued policy tightening by global central banks, may somewhat dampen the optimism regarding a sharp improvement in the demand for the government's papers. In the end, foreign investors may well demand higher yields before dipping further into the Indian debt space.

Apart from these demand-supply factors, a change in the Reserve Bank of India's (RBI) guidance has also mellowed yields. Despite earlier reservations on providing relief for trading losses, the central bank surprised markets by extending support to domestic banks. This was likely a move to offset further pain on their balance sheets 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).

Near-term worries on weak macro data have subsided, but longer-out caution remains

The RBI's dovish view on the inflation path at its April policy review also cheered bond bulls. Official inflation forecasts were lowered, alongside more conviction that GDP growth had bottomed out and was likely to gain momentum this year. Projected CPI inflation for 1H FY19 was revised to 4.7-5.1% (vs 5.1-5.6% earlier) and 2H to 4.4% (vs 4.5-4.6% prev). Excluding the impact of the housing rent allowance, the inflation path is seen at a more modest H1's 4.4-4.7% and 4.4% in H2. The RBI's decision to lower its full-year FY19 inflation forecasts was a surprising move, suggesting no imminent rate-hike risks. Policymakers are, nonetheless, likely to stay glued to upcoming developments. The impact of minimum support price hikes (details are likely in May / June) and the recent jump in domestic fuel prices on inflationary expectations will be under close watch. Severity of the inflationary impact also hinges on rural wage growth and procurement.

Apart from inflation, the near-term sting from weaker macro-stability indicators (widening current account gap, delayed fiscal consolidation etc.) is partly offset by improving high-frequency indicators, including industrial production, auto sales, real credit growth, amongst others. Our in-house GDP Nowcast model (see here) points to a strong pick-up in 1Q18 growth momentum for India. An eye on headwinds is likely in FY19 as India's exports performance has been lackluster in the middle of a global growth rebound; credit growth may well slow in the aftermath of high-profile governance slippages in the banking sector, and the tourism sector has been in a soft patch. Despite this, the Indian economy appears to be coming out of the shadow of demonetisation and GST rollout, with our growth estimate at a shade above 7%, but more conservative than consensus. In the meantime, any upside surprises in inflation coupled with weakening fiscal/CAD run-rate and higher oil prices in 2H FY19, just as global tightening will limit the scale of rally here on. On the global front, the pullback in US Treasury yields from the brink of testing 3% has also alleviated upside pressure on Indian / EM rates.

Range trade likely in the near term

As flagged in recent notes, bonds have traded with a positive bias in the past two weeks, with a flattening effect across the curve. With the FPI framework also out of the way, we expect 10Y yields to settle into the 7.1-7.3% range, before inching higher anew. This week's inflation numbers are under watch next (DBSf: 4.1% YoY), with any downside surprises to see yields inch towards the lower end of the range. Further out, risks of a break higher might stem from external developments (easing trade tensions putting the Fed back in focus) or domestic speed-bumps (unexpected pick-up in inflation and tightening fears). Surplus domestic liquidity conditions will, meanwhile, return towards neutral in the weeks ahead, in contrast to the vast post-demonetisation surplus that helped depress yields in the comparable period a year ago. Most of the duration play is likely behind us, with long-term bonds to offer intermittent tactical opportunities going forward. On a risk-adjusted basis, we think shorter-term bonds may be less susceptible to global volatility and issuance risks. We see steepening risks on the horizon.

Source : Equity Bulls

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