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Fed Rate Hike Won’t Dampen A Good Year For Indian Bonds

What started out looking like a dull year for Indian bonds turned into one of the most eventful in recent times.

Bond yields, which were flat in the first half of the year, reacted to a series of dramatic events in the second half of the year from the exit of Raghuram Rajan as Reserve Bank of India governor, to Britain’s decision to leave the European Union, and most recently, the Indian government’s decision to demonetise.

The year will likely be capped by another big event, albeit an anticipated one – the second interest rate hike from the U.S. Federal Reserve.

The Federal Open Market Committee which concludes a two-day meeting on Wednesday is widely expected to raise rates for only the second time in a decade. While a rate hike in December has been priced in to the global markets, analysts are now trying to judge whether the pace of rate hikes in 2017 may be steeper than earlier anticipated. The result has been a move up in the U.S. 10-year year bond yield to near 17-month highs close to 2.5 percent.

Indian bond markets, however, have marched to a different tune. A surge in liquidity following the withdrawal of Rs 500 and Rs 1,000 notes led to unusually high demand for government securities from banks and funds, which pushed yields down sharply. To normalise market conditions, the RBI is sucking out additional liquidity through the issue of market stabilisation scheme bonds.

From here on, Indian yields may slowly start to recouple with global bond yields, said R Sivakumar, head of fixed income at Axis Mutual Fund.

After the one-off repricing we saw last month due to demonetisation, in the last few days we have seen Indian bond yields catching up with global yields. Also the last policy conveyed a sense to the market that the RBI is far more sensitive to external events than what was believed.
R Sivakumar, Head - Fixed Income, Axis Mutual Fund

According to Sivakumar, one rate hike from the U.S. Federal Reserve this year and another next year is priced in. “But it is possible that the market is underestimating the pace of normalisation next year.”

Tushar Arora, senior economist at HDFC Bank shares the view that the immediate rate hike is factored into the market but adds that any indication of steeper than expected rate hikes next year could further push up global yields.

A 25 basis point rate hike from the Fed in December is already baked in. Markets are actually watching out for further cues about the rate hike cycle in 2017. In this regard, dovish commentary from the Fed could lead to near-term gains. However, a hawkish stance from the Fed officials, indicative of more than two rate hikes (next year) could lead to a sell-off.
Tushar Arora, Senior Economist - Treasury, HDFC Bank

Indian Bonds - Charting Their Own Course

Despite the anticipated hike in rates by the US Federal Reserve, the upside on Indian bond yields may be limited because of the expectation of lower policy rates and a sustainable improvement in banking sector liquidity.

Indian banks have received Rs 12.44 lakh crore in old currency since November 8 and while some of this liquidity will go back into the system in the form of new notes, banks may still be left with more liquidity than they had before the demonetisation. At the same time, while the Reserve Bank of India kept rates steady at its meeting on December 7, most in the market continue to expect a cut in the policy rate early next year.

Together, these two factor may allow Indian bonds to remain relatively insulated from fed-driven volatility across global markets.

A chart showing relative movement in bond yields until Monday December 12
A chart showing relative movement in bond yields until Monday December 12

According to a December 7 report from Nomura Global Research, the Indian 10-year bond yield is expected to trade in a range of 6.30-6.50 percent in the near term.

Despite the sell-off following RBI’s decision to keep interest rates unchanged, Nomura noted that ample liquidity in the banking system and weak credit growth will ensure strong demand for government bonds from the banking sector.

HDFC Bank, too, expects yields to remain close to 6.4 percent and trend back towards 6.25 percent.

After a surprise status-quo decision from the RBI, we saw around 20 bps rise in the domestic bond yields. While liquidity situation has remained comfortable till now, absorption through the MSS (market stabilisation scheme) and advance tax flows could soon bring it close to neutrality. Therefore, we expect the benchmark bond yield to remain close to 6.4 percent in the near term. Post December, as rate cut expectations are again factored in (for the next RBI meeting), we expect movement towards 6.25 percent.
Tushar Arora, Senior Economist - Treasury, HDFC Bank

Reason To Celebrate

Barring any unanticipated surge in yields over the next few weeks, Indian bonds are set to close 2016 on a strong note.

The benchmark 10-year bond yield has fallen the most since 2008, data compiled from Bloomberg shows. The initial drop in yields came starting mid-June after Rajan announced his decision to step down after his three-year term ended in September. This was followed by a global drop in yields brought on by Britain’s decision to exit the European Union, which was also reflected in India. After a brief period of stability, yields plunged again on the government’s decision to withdraw Rs 500 and Rs 1,000 notes, which pushed the 10-year benchmark below the policy repo rate for a brief period of time.

All combined, the 10-year bond yield was down 132 basis points in 2016 as of Friday’s close.

There have been quite a few events this year which have moved yields and the markets have reacted accordingly. But we can’t take our eye off the ball. Oil prices have started to go up and the Rupee has also weakened mildly so there could be some pressure on inflation down the line. At the same time, if growth normalizes, then we may be close to the end of the rate cut cycle.
R Sivakumar, Head - Fixed Income, Axis Mutual Fund
Fed Rate Hike Won’t Dampen A Good Year For Indian Bonds