India’s Bond Markets Remain In Desperate Need Of A Circuit Breaker
The bond market is yet to price in the risk premium of the 2019 General Elections, writes UBS’ Rohit Arora.
Nothing is going right for India bonds; inter-bank liquidity, the fiscal environment, inflation, the rebound in global growth and oil prices, are all the source of headwinds to a varying degree. The sole alleviating factor is that, on a number of metrics, valuations are now cheap. But valuations alone will not stabilise the market; a circuit breaker is needed. So, what will trigger a change? We discuss the drivers behind recent sell-off and see which driver is more likely to change.
First, liquidity. The liquidity that came gushing into the banking system post demonetisation has disappeared. Cash shortage was transitory, and so should have been its impact on a range of macro variables including gross domestic product, the Consumer Price Index and credit growth, which indeed are now normalising.
However, the illusion persuaded many to view the change as structural and bond markets to take a sanguine view and discount it as if it were here forever.
A year later, currency in circulation is back to where it was pre-demonetisation (up 82 percent year-on-year), bank deposit growth has declined to 5.1 percent (from 13.3 percent a year ago), while credit growth accelerated to 10.6 percent (from 4.7 percent a year ago). Markets just cannot seem to get over with the withdrawal symptoms. But the return of liquidity ain’t gonna happen on its own, and neither can the central bank be relied upon to supply it, especially when growth and CPI are expected to only pick up from here.
Second, the fiscal environment. While Budget 2018 was broadly balanced and in line with expectations, it did not bring positive surprises for the bond market. On paper, a balanced pre-election budget offered something for everyone i.e. fiscal consolidation absent populism. But the path to achieving that consolidation is narrow. A great deal depends on the success of the Goods and Services Tax, the efficient collection of disinvestment revenue, and rural spending.
Higher oil prices, helped by a strengthening global economy, are unlikely to come to the rescue in the near-term.
Third, inflation. With the fiscal drama now largely over, inflation will be a key driver of the next leg of the sell-off. If oil prices stabilise here, they will be up around 40 percent year-on-year by June — a non-negligible increase. UBS estimates that every 10 percent increase in oil prices, boosts inflation by 25 basis points. And, it is not only oil. The FY19 budget commitment to keep minimum support prices for crops at 1.5 times their cost of production could mean another 15-20 basis points increase in CPI inflation. Lastly, the ongoing rebound in cyclical indicators (the Purchasing Managers Index, industrial production, and credit growth) mean the demand side pressure on inflation is only likely to increase. CPI inflation, which has already crossed the Reserve Bank of India’s 4.3-4.7 percent estimated range for the period from October 2017 until March 2018, can temporarily go above the RBI’s 2-6 percent CPI target range.
Fourth, global growth. At the same time, a rebound in external growth may not be helpful either. Survey data, in the form of Global Manufacturing PMI, suggests that global economic growth is on the cusp of its fastest acceleration since 2011. The three-month change in the PMI is at the top tenth percentile of past seven years. Ten-year U.S. bond yields, which are only reflecting the good news, also mean that normalising G3 (U.S., European Union, Japan) yields could add further upside pressure to investment-grade bond yields.
What breaks the circuit? Perhaps a strong signal that domestic activity and hence core CPI are not going to accelerate further; a sizeable increase in foreign investment limits for debt markets; or an affirmation by the Monetary Policy Committee that it does not plan to hike on temporary inflationary pressures from oil or housing allowances. None of the three options appears likely in the near-term.
The MPC meets on February 7, and turning dovish is not a viable option. In fact, a dovish stance, even if it helps bonds in the near-term, could significantly damage the Rupee (possibly more than the damage from oil). The last thing markets need now is the central bank risking its inflation-targeting credibility, especially when inflation is going north. This could potentially risk simultaneous debt and equity outflows at a time when a shrinking basic balance (current account balance + net foreign direct investment) needs them the most. Yet fundamentals are in relatively good shape and its nowhere near levels of 2012-2013, so these are manageable risks. A far bigger risk is the 2019 elections, the risk premium of which has yet to be factored in.
Rohit Arora is an emerging markets strategist at UBS. (Disclosure)
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.