Bonds rise on rate cut hopes

However, the RBI expects inflation to rise again to 3.5-4.5% in the 2nd half of the FY18

Bonds rallied on Tuesday, as chances of a rate cut by the Reserve Bank of India (RBI) strengthened after the soft inflation print on Monday.

Retail inflation dipped to 2.17% in May, far lower than the RBI’s own target of keeping inflation at the mid-point of 4%. The central bank, however, expects inflation to rise again to 3.5-4.5% in the second half of the financial year. Of course, this is lower than what the central bank was expecting earlier. 

The yields on the benchmark 10-year bond fell to 6.47% intra-day, its lowest since it was introduced in May, but climbed to close at 6.49%. The US Federal Reserve is expected to raise rates when it finishes its two-day meeting on Wednesday. 

The yields had closed at 6.51% on Monday. Before the June 7 monetary policy, the yields were at the 6.64% level. 

The sharp drop in inflation, which some economists expect to fall below 2%, should coerce the central bank to cut rates by at least 25 basis points in the August policy. 

State Bank of India (SBI) Group Chief Economist Soumya Kanti Ghosh expects inflation to fall below 2% for the next two months before rising below the 4% level.

“With real interest rate at a 15-year high in FY17 and inflation near 2% level now, the RBI cannot avert a rate cut in the August 2017 monetary policy meeting. The expectation of a prominent rate cut would become more pronounced if inflation continues to remain benign for a longer time,” Ghosh wrote in his note. 

According to Pranjul Bhandari, chief economist at HSBC India, the “lower inflation and unexciting growth print raises the risk of a rate cut in the RBI's August monetary policy review”.

While bond markets also share the same view, but much of the movement in bond yields has already taken place. Now, a more substantial yield movement can happen only after any actual rate hike, economists say.

“There is not much of scope for yields to fall further. The Treasury bills are trading at around 6.40% level, the 10-year cannot fall much,” said Devendra Dash, head of treasury at AU Small Finance Bank.