The bond landscape in India has experienced notable fluctuations within recent months. The interest rates on 10-year government bonds took a dip from 7.45% to 7%, only to rebound to the range of 7.25-7.35%. This rollercoaster ride can be attributed to the surge in US bond yields and the volatility in crude prices.
Indications strongly suggest a metamorphosis in market dynamics, elucidated through three prisms:
Fundamental Shift:
Delving into the macro tableau underscores the rationale for integrating bonds into the investment portfolio.
Structural Transformation:
Altering market demand-supply dynamics propels the case for longer-duration bonds.
Relative Perspective:
Drawing on historical perspectives accentuates the historical dominance of bond markets over other asset classes.
Fundamental Undercurrents
Inflation Dynamics:
Headline inflation hovers around 5%, with core inflation demonstrating a downward trajectory. Foreseeably, it may dip below 5% due to decelerating growth in China and the frail global economic backdrop, expected to keep commodity prices in check.
Economic Growth:
India’s GDP growth appears to have reached its zenith, poised to linger around sub-6% levels for the ensuing two years. This decline is attributed to the waning fiscal impetus and vulnerabilities in global economies.
Positive External Standing:
India’s external position remains robust, considering the trinity of Forex reserves, balance of payments, and current account deficit. Could China’s setback be India’s advantage? Quite plausibly!
Narrowing US-India Interest Rate Gap:
In response to the pandemic, the US government escalated spending to unprecedented levels, resulting in wider fiscal deficits (escalating from sub-3% to 8-10%), a substantial expansion of the US Fed balance sheet from $1-2 trillion, and a accommodative monetary policy stance sustained for 2.5 years.
The cumulative impact of lax fiscal and monetary policies in the past 3-5 years has triggered a robust growth and inflation spiral. Over the last 12 months, the US Federal Reserve implemented interest rate hikes totaling 500 basis points, concomitant with shrinking the US Fed balance sheet from $3 trillion to $1 trillion. One basis point equals one-hundredth of a percentage point.
The diminishing interest rate differential has placed the Reserve Bank of India (RBI) in a precarious position. Yet, unless a substantial rupee depreciation or heightened outflows materialize, an interest rate hike by the RBI remains unlikely. In the past two months, the RBI has already orchestrated a 25-basis point rate increase through stringent liquidity conditions.
Consequently, bond markets are pricing in a substantial portion of the negatives, the macro theme aligns favorably, and fundamentally, the rates cycle presents an optimistic outlook.
Structural Unfolding
A pertinent question looms over bonds concerning elevated fiscal deficits and a considerable supply of government bonds, raising apprehensions about bond yields. Scrutinizing the trend over the last 5 years reveals a consistent structural demand-supply gap ranging from ₹50,000 to ₹1.5 trillion annually, where supply surpasses demand. This gap is bridged by open market operations (OMO) purchases by the RBI.
Nonetheless, recent years have witnessed a notable surge in assets under management/flows from ₹55 trillion to ₹85 trillion. This surge has effectively mitigated the substantial demand-supply gap despite ambitious government borrowing plans.
Moreover, an anticipation of the fiscal deficit normalizing from 6% to 4.5% over the next 3 years allays concerns of a significant uptick in borrowing figures. With India’s Sovereign bonds entering JP Morgan Global indices, an inflow of $25 billion is anticipated in the next 12-18 months, significantly favoring the demand-supply dynamics for bonds.
Relative Outlook
While bonds are conventionally viewed as a stable asset class over the long haul, a counterintuitive trend emerges. Contrary to popular belief, debt has outperformed other asset classes during periods of extreme/lengthy interest rate hikes and stringent financial conditions.
In summation, following a thorough examination of the fundamental, structural, and relative themes, our counsel advocates a heightened allocation to debt in the coming 12-18 months. A few macro risks loom large, including escalating crude oil prices, China’s recovery, and the potential devaluation of China’s currency to attract capital flows.