Additional government borrowing is a key step to break the impasse

There is no shortage of uncertainties for bond market participants these days.

Against that backdrop, the October 15 announcement of additional government borrowing of Rs 1.1 trillion had been an important one. Seemingly, any announcement of additional supply has to be a negative one. However, one feels that this announcement needs to be evaluated in a more holistic way against the backdrop of the prevailing conditions and concerns of the market and the broader economy.

Given the persisting revenue shortfall of central and state governments, additional market borrowing did not come as a major surprise. Thus, irrespective of the market's immediate knee jerk reaction, one feels that the current set of announcements should not be seen as a fresh negative that the fixed income market needs to grapple with.

Reducing Uncertainties

Rather, the recent discussions among the central and various state governments regarding the approach to compensate for the states’ revenue losses failed to arrive at a conclusion. This had virtually led to a situation of stalemate and, thus, higher uncertainties and speculations as regards the quantum and timing of additional borrowing to be eventually carried out by various market participants.

After the October 15 announcement, it is likely that the borrowing will be done initially by the Centre and the proceeds will be used to take care of the needs of the sates. This clarity should help in reducing uncertainties and anchoring market sentiment over the coming weeks, especially given the intelligent selection of the maturity buckets for the additional borrowing that enjoy strong demand.

Yield Curve To Flatten Further

The calendar is now spanning up to mid-March and the market, at least for the time being, tends to believe the current announced quantum will not be exceeded during 2020-21. Moreover, the additional borrowing is entirely in the 3-5 year segment, which enjoys strong demand, especially since the August announcement of the enhanced held-to-maturity (HTM) limits for commercial banks. Borrowing in the segment of bonds of 10 year or longer is relatively less as per the new calendar.

This has started further flattening of the yield curve. Indeed, as the immediate reaction of the announcement, while the five-year bond yield moved up by over 10 basis points, 10-year yield moved up by just three basis points, while the 30-year yield barely moved. Effectively, the 5-30 year spread, which stood at over 160 basis points prior to the announcement, has already moved to around 150 basis points and one would expect the same to soften significantly to close to 100 basis points; this may eventually help in better transmission of the Reserve Bank of India’s monetary easing. India’s yield curve of late had been much flatter than a number of countries, and one expects that trend to continue in the coming months.

Bond Market Support

Given the importance of fiscal spending to support economic activities, one would expect policymakers to stay committed to provide support for the bond market. For example, the RBI’s recent decision to increase the quantum of weekly Open Market Operations (OMOs) and to conduct OMOs on State Development Loans (SDLs), along with extension of Held-To-Maturity (HTM) till March 2022, should help easing concerns about market’s absorptive capacity for government borrowing during 2020-21. Going ahead, the RBI may also consider issuing larger quantum of securities in the 10-year bucket to ensure better liquidity in the benchmark segment.

Finally, one clearly expects stepping up of the overall quantum of the OMO purchase during H2 2020-21. While the RBI refrained from announcing an OMO calendar at the time of the October monetary policy committee (MPC) meeting, the guidance of conducting ‘market operations in the form of outright and special open market operations’ should be comforting.

Meanwhile, uncertainties galore related to the RBI’s potential moves on the rate front as well. Soon after a markedly dovish MPC statement, the shockingly high September CPI print seemingly posed fresh challenges to prospects of monetary easing anytime soon. However, our assessment of the evolving growth-inflation dynamics clearly suggests further rate easing during 2020-21.

With such possibilities, and the policymakers’ continued focus on market microstructure, there is clearly room for the benchmark 10-year bond yield to soften by about 50 basis points during the coming months from its current reading of about 5.90 percent.

 Siddhartha Sanyal is Chief Economist and Head of Research, Bandhan Bank. Views are personal.