Fixed income outlook: Yields on long-term paper to remain elevated

A surprise move by the Reserve Bank of India (RBI) to raise the repo rate by 25 basis points (bps), direct reference to follow the Consumer Price Index (CPI)-based inflation according to the Urjit Patel committee report, emerging market (EM) sell-off starting from Argentina, Turkey, South Africa and its left over contagion effect on India, a lower Purchasing Managers Index (49.6) print in China and the Federal Open Market Committee heading towards a further reduction of $10 billion in their quantitative easing (QE) on Wednesday, are factors that can lead to an elevated yield curve and an extremely volatile Indian bond market.

Where do interest rates and bond markets move from here? RBI action in raising the repo rate, to that extent, is consistent with increased inflation focus and will help achieve a "disinflationary glide path" to lower CPI inflation. While it is not stated, we believe it was also a sort of pre-emptive action to avoid EM weakness hitting the rupee. Though India is much better positioned than in May-August 2013, with current account deficit expected to be below 2.5 per cent of gross domestic product and foreign currency non-resident (banking) deposit scheme, which helped enhance reserves to over $292 billion, global risk-off phenomena, especially related to currencies, sometimes snowballs across markets. If one looks at currency movements over a year, it is interesting to note that the rupee has performed better than most other EMs such as Brazil, South Africa, Indonesia, Argentina and Turkey. This is mainly due to some very inventive and proactive action by RBI governor Raghuram Rajan. In the same vein, the 25 bps rise, other than addressing inflation concerns, would help the rupee and shows the foresight and global perspective of Rajan.

If the recommendations of Urjit Patel committee report are accepted fully, there seems a less chance of any rate cuts until the fourth quarter of 2014-15. RBI's base case (with 50 per cent confidence) projects CPI in the range of eight per cent by December 2014. Most other economists would probably peg it a little higher, even without considering any unforeseen monsoon or crude oil shocks. Food inflation is not highly correlated to policy rates and is driven more by inefficient supply chain, administered pricing, speculative hoarding and monsoons. This is not the case for many countries that have inflation targeting policies. Therefore, after this increase, we do not expect policy tightening in the near term and any easing will be likely only if CPI prints below eight per cent, which we do not anticipate until the end of this year.

We believe the primary drivers of bond yields will be: a) affinity of RBI for a 'quantitative target stance' b) a contained EM sell-off specific to India (as we seem better positioned to withstand external shocks, as seen from recent inflow of funds both in long-term bonds and equities) c) the large gross supply of government paper in FY15 to finance the fiscal deficit.
In such situations, we expect the longer end to remain elevated taking cues from RBI forecast on inflation trajectory. Whereas the short-end of the curve will have progressive bias towards softening in line with RBI's firm commitment to keep sufficient liquidity in the banking system.

The bottom line is, we expect near-term yields to remain between the repo and the Marginal Standing Facility rate (up to one year), with the corporate curve priced between 60 to 100 bps over the Treasury bill curve. Similarly, until further clarity emerges, 10 year government securities are expected to be in the range of 8.65-8.85 per cent.
The author is head, global markets group, IndusInd Bank