Sovereign bonds benefited from correction in oil prices, says DBS bank

India's sovereign bonds rallied sharply in late-2018, benefiting from a confluence of a correction in oil prices, receding expectations of an aggressive US rate hike cycle and pullback in US rates, banking group DBS said Wednesday.

A string of weak inflation prints at home and perception that the incoming RBI Governor might soften the policy stance pushed the curve lower, wrote DBS Group Research Economist Radhika Rao and FX Strategist Philip Wee.

The 10-year yields hit a low of 7.22 per cent (generic), down nearly 100 basis points from the year's high, with the short-tenor rates down by 120-140 basis points to slip below 7 per cent.

Add to these, the central bank's active liquidity injections through open market operations (OMOs) have also been supportive of bonds, Rao and Wee pointed out.

Apart from increasing December bond buybacks by Rs 100 billion to Rs 500 billion, the RBI announced plans to buy Rs 500 billion in January.

This will take FY19 OMOs by Jan-end to Rs 2.48 trillion; highest in over a decade.

As of December, bond purchases stood at 40 per cent of the gross bond supply. On a net basis, supply was in negative for the past two months, said Rao and Wee.

Caution is creeping in at the longer-end of the curve as focus returns to the FY19 fiscal outlook, Union Budget and India's general election.

There are underlying concerns that bond issuance might be stepped up to meet pre-election spending, as speculation over either a universal basic income, income support scheme or farm loan waivers make rounds, wrote the duo.

A mix of pullback in OMOs, coupled with modest fiscal miss (if not accompanied by RBI's dividend contribution to the state's coffers) is likely to draw the brakes on the 10-year rally.

Recent RBI Governor's comments that liquidity injection will be fine-tuned to maintain a neutral balance, rather than surplus liquidity; these drew in profit-takers and pushed 10-year bond yields up.

We note that this week's sharp bounce past 7.6 per cent, before yesterday's (Tuesday) close at 7.53 per cent is attributable to the issuance of a new 10-year benchmark. 10-year yields are likely to stay biased for gains in 7.45-7.6 per cent range, said Rao and Wee.

Steepening of the bond curve is bound to continue as a dramatic disinflationary spell increases scope of a change in policy stance, keeping a lid on short-tenors particularly two-year yields.

Apart from benign inflation of 2.0-2.8 per cent in the coming months, a commitment to keep the fiscal deficit close to its FY19 target of -3.3 per cent of GDP (at the interim budget announcement on 1 February) will be closely watched for a shift to a neutral stance at next RBI review on 6 February.

With expectations now veering from policy tightening to rate easing scenario, we are of the view that the 2-year rates have further downside," they said.