Bears tightening grip on global bond markets: How would domestic bonds react?

Most of the major global central banks are now in the process of withdrawing the unprecedented stimulus measures that were in place since the great financial crisis.

The US Fed announced balance sheet reduction (BSR) in its September policy. The Federal Reserve is going to stop reinvesting its holdings of US Treasuries and Agency Mortgage-backed securities at a gradual pace.

As of now, after the first year since the commencement of BSR, the pace of unwinding of US Treasuries would be USD 30 billion per month and that of MBS would be USD 20 billion per month which is quite modest.

The ECB has cut down its monthly asset purchases from EUR 60 billion to EUR 30 billion per month. Latest ECB meeting minutes suggest that the governing council could consider further tapering in early 2018 itself.

The move in the Euro and the German Bond yields post the release of the minutes implies the market was anticipating taper to be much more gradual than what the minutes seem to suggest.

Even though the Bank of Japan has not officially changed its policy stance, it has started reducing its purchase of government securities, a move that many economists refer to as ‘stealth tapering’.

Considering that the growth in Japan is the best it has been since the 1990s this stealth tapering could become more explicit and official. Through the recent moves in EUR/USD, USD/JPY, German Bunds, and JGBs the markets have already begun pricing in a substantial degree of central bank hawkishness.

However, any unforeseen hawkishness due to inflation picking up with a lag could drive yields much higher from current level.

The major threat to consensus bearish view on rates would stem from one or more of these central banks changing their monetary policy frameworks and relinquishing their pursuit of the 2 percent inflation target, acknowledging structural changes that have taken place in the economy (changing demographics and role of technology).

Wage growth and inflation are not picking up in developed economies despite output gap being almost closed and unemployment being close to record lows.

Such low inflation and wage growth at this stage of growth cycle is an unusual phenomenon that these central banks are confronted with.

The possible options that the central banks could likely consider are targeting price levels or nominal GDP instead of inflation (The Federal Reserve may set up a committee to explore this).

This would mean that if the central bank undershoots its price target for a particular year, the monetary policy would be more aggressive the following year. This change in policy framework would help central banks deal with the problem of zero lower bound (ZLB).

The fact that the volatility on 3M options on 10Y treasury futures continues to remain low, unlike during the taper tantrum in 2013, indicates that investors do not see a major move in US yields from current level.

According to the latest FOMC dot plot, the median nominal neutral federal funds rate is 2.7 percent. If current economic conditions persist, we would attain that level somewhere around mid-2019, considering three hikes in 2018.

From a demand-supply dynamics perspective, the supply of US Treasuries is likely to be higher this year owing to higher hurricane-wildfire, defense-related spending and revenue shortfall on account of recent tax cuts.

Coupled with reduced demand on account of BSR, the additional supply may weigh on US treasuries. Senior Chinese officials have proposed reducing purchases of US Treasuries and if this proposal is accepted, it could put upward pressure on US yields.

On the domestic front, from rates point of view, there are two concerns: Fiscal slippage and inflation. Most likely the government may miss its fiscal deficit target for the year on account of lower indirect tax collections (on account of reducing the GST rate from 28 percent to 18 percent on several items and lower dividend from RBI).

The April-November fiscal deficit stands at Rs 6.12 lakh crore which is 112 percent of the budgeted fiscal deficit for the entire financial year and therefore unless there is a major expenditure cut, fiscal slippage looks imminent at this point.

We will get more clarity on the fiscal front from the Union Budget on February 1. It will be interesting to see if the government adheres to the glide path for the fiscal deficit (as a percentage of GDP) recommended by the NK Singh committee.

More than the fiscal slippage, the quality of expenditure would matter more to investors. The market may not take fiscal slippage negatively if the increased spending is directed towards CAPEX and job creation rather than towards wasteful subsidies and populist measures.

Increased government borrowing entails the risk of crowding out the corporate sector especially when disintermediation post demonetization has resulted in an increased share of non-bank financing as a percentage of overall corporate borrowing.

The government would also face a challenge due to rising crude prices. The positive terms of trade shock that the economy has benefited from will dissipate and the government would not be able to pass on the entire rise in global crude prices to customers due to political constraints (especially with several state elections lined up and with the general election looming in 2019).

A USD 10 per barrel rise in crude prices affects our fiscal deficit negatively by 0.1 percent and CAD by 0.4  percent of GDP. The latest CPI print for December came in at 5.21 percent.

With inflation bottoming out and on the rise, the investors have come to terms with the fact that the rate cut cycle may be over and that the RBI may head into a phase of prolonged pause, especially if US yields continue to head higher.

Food inflation is expected to remain under control as the agriculture ministry estimates a normal Rabi harvest despite lower acreage so far.

Despite the domestic concerns, the FPI appetite for domestic bonds does not seem to have waned. The debt utilization status for FPIs is close to full (in case of general category FPIs) in government as well as corporate debt.

Auction of new limits is receiving an enthusiastic response as well. Limits are opened up for FPIs in line with RBI’s medium-term framework announced in October 2015 so as to reach 5 percent of outstanding G-Sec stock by March 2018.

Any announcement of an increase in limits beyond 5 percent of the outstanding stock for FPIs would be positive for G-Sec if global risk sentiment remains positive. The low volatility of rupee has been another factor that has contributed to FPI’s confidence of investing in domestic debt.

An uptick in currency volatility could spook FPIs and trigger debt outflows. Liquidity situation normalizing in due course would see an end of OMO sales by the central bank.

In fact, the RBI may have to resort to OMO purchases in next fiscal if the need arises and this would support domestic bonds.

To sum up, the major threat for domestic bonds (in decreasing order of magnitude) stems from the rise in global rates on account of more hawkish major central banks, crude prices sustaining above USD 60 per barrel, fiscal slippage on account of populist measures and an uptick in currency volatility.

Positive catalysts, on the other hand, would be major central banks revising their respective monetary policy frameworks, increase in debt limits for FPIs.

Technically, 2.65-2.75 percent seems to be a major resistance for US 10-year yields. The new 10-year benchmark IGB is likely to face resistance around 7.50  percent in the near term.

Disclaimer: The author is Founder and CEO of IFA Global. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.