Kunal Shah
The bond market remained in a narrow range of 7.75-7.90 percent (10-year G-Sec) last month after the Monetary Policy Committee’s interest rate hike on June 6. The rate hike was anticipated and yields remained in a narrow range. The minutes, which followed on June 20, re-affirmed the data dependent approach by policymakers.
However, the mildly dovish tone by some members led to a relief rally in bonds, pulling the yields below 7.80 percent briefly. The major mover for bonds continued to be movement in oil prices and the Organisation of the Petroleum Exporting Countries' decision to enhance output.
After the mild drop, yields tracked Brent prices and currency movement closely. Yields on the 10-year bond have firmed up to 7.90 percent as Brent once again is closer to $80 per barrel mark and the rupee has depreciated above Rs 68.50 to the dollar.
A couple of developments in the bond market will determine the direction of yields in the near term. We have seen nationalised banks returning to the bond market (albeit at a slow pace). In the recent auction, higher-than-expected cut-off reflects demand accruing from nationalised banks after long-period of buying a strike.
Absolute yields appear attractive at 7.90 percent when inflation is around 5 percent. Replacement demand of open market operations (OMO) sales seems to have worked. This trend needs to be tracked.
The Reserve Bank of India has purchased Rs 20,000 crore bonds to replenish liquidity, which tightened after its forex intervention. Pressure on Balance of Payment due to continued dollar outflows will keep RBI busy in the forex market. The resultant effect will be tighter rupee liquidity and RBI OMO purchases of bonds.
In a way, it can be seen as RBI compensating for foreign institutional investor (FII) selling in the bonds market. FIIs have sold close to $6.5 billion of Indian bonds this fiscal due to tightening policy back home and rupee depreciation versus the dollar.
From an economic point of view, the much awaited minimum support price (MSP) hikes will provide some direction on the inflation path for the rest of the year. Economists are divided on the inflation impact of MSP hikes, the range being from no impact to a 50 basis points one in the near term.
The final impact of MSP hikes and direction of crude oil prices will determine the policy rate in coming quarters. The most dovish scenario being one more hike to 6.5 percent then a long pause. On the other hand, higher oil prices will push the policy rate to 6.75-7 percent.
Given the current bond and swap yields, market participants are expecting more than 2 rate hikes in the next 6 months. Hence, current yields in the 5-10-year segment appear quite attractive if oil remains below $80 per barrel and RBI continues to manage liquidity via OMO.
The next big unknown for the market will be how the fiscal math plays out in the remaining part of the year and developments in the domestic political landscape given next year’s general elections. Till then, bond yields should trade in the 7.70-8.10 percent range for the next month or so. Investors with a 2-3 year horizon should look to add duration risks at current levels in the bond market, with favourable risk-reward from here onwards.
Disclaimer: The author is Debt Fund Manager, Kotak Mahindra Life Insurance Co. Ltd. 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.
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