After two rate cuts of 25 bps each in the two monetary policy reviews announced this year in January and March, the sentiments in the bond markets remained upbeat in the month of April on expectation of further rate cuts. Hope of another round of rate cut grew stronger after the easing of Consumer Price Index (CPI) as well as Wholesale Price Index (WPI) based Inflation for the month of March. Domestic bonds also benefitted during the month from worsening economic conditions globally, which further improved odds of policy easing by the RBI. The global risk aversion resulted in a sharp fall in crude oil prices, lending another positive cue to bonds as it has a cooling effect on domestic inflation
In a nutshell, the inflation numbers and the fall in commodity prices globally left little doubt over the likelihood of a 25 bps cut in repo rate by the central bank in its Annual Monetary Policy review (announced on May 3, 2013). Driving on this phenomenon, bond yields speeded down during the month. However, profit booking by market participants at regular interval prevented a further fall in bond yields. Also, surge in global crude oil prices towards the end of the month added a bit of uncertainty over further rate cut by the RBI. But in line with market expectations, RBI announced a 25 bps cut in repo rate in its Annual Monetary Policy review on May 3, 2013.
Bond yields nosedived across tenor during the month. The fall in yields was sharper at the shorter-end of the yield curve, than at the longer-end. Bonds of relatively short maturities gained due to strong buying support from foreign institutional investors. The yield on the 10 year benchmark 8.15%, 2022 bond, fell by 22 bps to 7.73% from the previous month’s close of 7.95%. However, it’s worth noting that the government is expected to soon issue a new 10-year benchmark bond, which would send the current 10 year benchmark 8.15%, 2022 bond, out of favour.
Easing inflation lent support
The foundation of the fall in bond yields was laid by the easing of CPI and WPI based Inflation numbers, which renewed hopes of a rate cut by the RBI. The data released for the month of March showed CPI based inflation reversed course and recorded its first fall in five months. It fell to 10.39% in March, after touching an all-time high of 10.91% in February. The data came as a source of relief as in its last two policy reviews the RBI has expressed concern over the high rate of retail inflation, which was treading deeper into the double digit territory.
Subsequently, fall in headline inflation rate, as well as core inflation for March further strengthened the case for RBI to cut rates. Headline inflation rate based on the WPI fell to a 40-month low of 5.96% in March from 6.84% a month ago. Non-food manufactured products inflation, which is considered a proxy for core inflation, fell to 3.5% in March from 3.8% in February.
In the light of the fall in inflation numbers, bonds largely remained unaffected by the data showing a surprise rise in industrial output for February. Contrary to expectations of a 1.0% contraction, industrial production expanded 0.6% in February, against a growth of 2.4% in January and 4.3% a year ago.
Some measures by the government improved market sentiments
With the government in the process of finalizing the details of inflation-indexed bonds, they are expected to be issued in May, depending on market conditions. As part of its Rs 3.49 trillion gross borrowing in Apr-Sep, the government is expected to issue Rs 120-200 bn of inflation-indexed bonds. The prospect of inflation-indexed bonds being issued next month improved market sentiment, as their issuance will give some respite from the incessant supply of dated securities, especially in the supply-packed month of May. May is the heaviest month in the government's borrowing calendar for Apr-Sep, with bond sales worth Rs 750 bn lined up. If inflation-indexed bonds form a part of this supply, the pressure on dated securities will be somewhat lesser.
The government also announced to cut the withholding tax rate on foreign investment in gilts to 5% for two years from 20%. The move to cut the withholding tax is viewed as a very positive one, as it is expected to boost flow of money into gilts.
Global risk aversion boosted domestic bonds
Global risk aversion, spurred by fresh concerns over the US economy's recovery, increased the appetite for bonds back home. Some disappointing economic data that were released in the month of April suggested that the world's largest economy is still struggling to get back on its feet. Further, a sharp fall in global prices of gold and crude oil, India's top two imports, is expected to ease the pressure on the current account deficit. Domestic bonds benefit from worsening economic conditions globally and fall in global commodity prices as it increases the room for the central bank to cut rates.
RBI cut repo rate by another 25 bps amid hawkish guidance
While announcing its Annual Monetary Policy review on May 3, 2013, the RBI warned it had limited room for further monetary easing, although delivering a 25 bps cut in the key lending rate, in line with expectations. With this rate cut, RBI had cumulatively cut repo rate by 75 bps this year so far. Besides this, the central bank also lowered the amount of bonds that banks can hold till maturity (HTM), as part of their government bond holding, by 200 bps to 23%, while leaving the cash reserve ratio unchanged, thus disappointing bankers. The reduction would be in a phased manner by way of at least 50 basis points each quarter beginning June. The RBI warned that the risk of inflationary pressure persists despite a recent sharp decline in WPI inflation, and said a high current account deficit poses the biggest risk "by far" to the Indian economy. The RBI said it expects the economy to expand 5.7% in the current fiscal year, lower than government forecasts.
What lies ahead
As per the recently released industrial growth data for March, which bounced back at 2.5% as against 0.46% in February, the economy is showing signs of recovery. However, markets would closely watch the release of inflation numbers for the month of April to draw cues on future interest rate movement. Bonds may trade under pressure given the month of May is loaded with the heavy supply of dated securities through weekly auction. But RBI’s decision to conduct open market operations to infuse liquidity into the system can have an offsetting effect on the same. Infact, RBI Governor Duvvuri Subbarao, while announcing monetary policy review, said that OMOs were "as good as" a cash reserve ratio cut, "if not better", to manage liquidity. Later, the RBI also announced a buyback of bonds worth Rs 100 bn on May 7, 2013. Also on market’s radar would be the issuance of the new 10 year benchmark bond.