Bond market rally may continue for a few more months

Yield on 10-year gilt closed at 6.5% on Friday, about 14 basis points down from pre-policy level

The Reserve Bank of India's (RBI's) dovish language on inflation and a clear indication of a willingness to cut rates further, if inflation remain tamed, have swung the bond market into action.

Bond yields have been rallying since the policy announcement on Wednesday and the market expects yields to drop further, albeit after intermittent corrections.

The yield on the 10-year gilt closed at 6.5 per cent on Friday, about 14 basis points down from the pre-policy level. The bond market is now divided over whether a rate cut would come in the August policy or later.

But, the cloud of uncertainty over a rate cut is largely removed. Earlier the market was expecting no rate cut this calendar year and some were expecting the present rate cycle to have reached its lowest and would reverse from the middle of calendar year 2018.

But after the central bank lowered its inflation expectation sharply in the June policy, the market is now expecting a rate cut or two this calendar year.

The central bank said on Wednesday it expected consumer price inflation (CPI) in the range of 2-3.5 per cent in the first half of the fiscal year and 3.5-4.5 per cent in the second half. Earlier, the central bank was expecting average 4.5 per cent in the first half and 5 per cent in the second half.

"The market is now expecting even two rate cuts of 25 basis points each," said Jayesh Mehta, head of treasury at Bank of America Merrill Lynch (BofAML).

This means that bond yields have now adequate room to fall. Going by the text book, for every 25 basis point cut, bond yields should also fall by about 20 basis points. But in reality the fall is about 20-25 basis points for every cut over a period of a fortnight.

The yields have already moved some 14 basis points in two days.

"Bond yields more or less have already factored in a 25 basis point rate cut," said Ram Kamal Samanta, vice-president, treasury, at SBI DFHI Ltd.

This is not only a great time for domestic investors, but foreign investors are also finding a lot of value in the market.

"India is a straight buy," said a senior bond dealer at the Indian arm of a foreign portfolio investor (FPI).

"FPIs have been taking positions in this market for many months and they would like to wait out some more to book profits," said the FPI bond dealer, requesting not to be quoted as he was not authorised to speak with the media.

This is a clear indication of yields falling further.

Net of sales, FPIs have bought Rs 76,700 crore of Indian bonds so far this year. March (Rs 26,000 crore), April (Rs 19,400 crore) and May (Rs 20,200 crore) saw an unprecedented bond buying spree by these investors. And the market expects this to continue, at least till August.

"Most of the movement in the last two days was led by FPIs. There will be profit booking corrections and then subsequent buys too. Those who have missed this rally will crowd in by before the August policy," said Mehta of BofAML.

However, FPIs can buy up to a certain limit and that is getting exhausted pretty fast. Data shows that foreign investors have already exhausted 88.3 per cent of their Rs 1.85 lakh crore quota in government bonds.

In corporate bonds too, nearly 90 per cent of the Rs 2.44 lakh crore quota has been exhausted.

But an added advantage is the tremendous stability in the local exchange rate. If the currency depreciates, foreign investors lose out on their returns.

"The bullishness in the bond market should continue till September, or at least the 10-year yields remain within the range of 6.40-6.60 per cent. The stability in the rupee is making India quite an attractive market for FPIs and they should continue taking positions here," said Samanta of SBI DFHI.