Bond market volumes touched all time highs of Rs 1,23,725 crore on electronic screen on 9 May, 2013. Ten-year benchmark government bond yields dropped to levels last seen in July 2010 on the back of heavy demand for government bonds.
The benchmark ten-year government bond, the 8.15% 2022 bond yield closed at 7.60% on 9 May, down 100 basis points (bps) on a year-on year-basis and down 30 bps since the beginning of April 2013. The question is whether the rally is overdone or whether it has more steam.
The answer is that the rally is not overdone and the ten year bond can potentially fall to levels of 7% over the next eleven months, a fall of 60 bps from current levels of 7.60%. The reasons for bond yields coming off going forward are a) slowing economic growth b) falling inflation expectations c) lower fiscal deficit and current account deficit d) search for yields by global investors and e) domestic demand for government bonds.
RBI has forecast India’s economic growth at 5.7% and Wholesale Price Inflation at 5.5% for fiscal 2013-14. India’s GDP growth has come off from levels of 8.4% seen in 2010-11 and the growth expectations for the next few years are closer to 7% levels than 9% levels. Slower trend GDP growth is positive for inflation expectations. Global factors too are helping inflation expectations with the shale oil revolution in the US lowering the US imports of oil leading to lower price expectations for global crude oil. Oil prices are down over 8% over the last one year.
Global economic growth outlook is not positive with Eurozone in recession, US growth is sluggish at 2.5% for the first quarter of 2013 (expectations were around 3%) and China forecasting growth at 7.5% for 2013 against levels of 7.8% seen in 2012. Inflation expectations are down globally on the back of weak growth prospects and the fall in global inflation expectations is positive for stable to lower outlook for domestic inflation expectations.
India’s fiscal deficit for 2013-14 is projected at 4.8% of GDP from levels of 5.9% of GDP seen in 2011-12 and 5.2% of GDP seen in 2012-13. The lower fiscal deficit projections keep government borrowing in check with the government budgeted to borrow Rs 484,000 crore net in 2013-14 against a borrowing of Rs 464,000 crore net in 2012-13, a growth of 3.6% against a growth in borrowing of 7% seen in 2012-13 over 2011-12. Government is running a cash surplus of Rs 100,000 crore as of May 2013 and this cash surplus will help the government override any shortfall in revenues or any unforeseen rise in expenditures.
The Current Account Deficit (CAD), which is a big concern for the RBI as it is twice above sustainable levels of 2.5% of GDP is expected to come down in fiscal 2013-14. RBI expects the deficit at around 4.5% of GDP while other economists expect the deficit to come in even lower at below 4% of GDP. Falling CAD helps RBI in lowering the repo rate further from levels of 7.25%. The repo rate has come off from levels of 8.5% seen in early 2012.
Central banks from the US Federal Reserve to the ECB are keeping policy rates at record low and adding liquidity into the system through bond purchases. The central banks' policy actions have led to bond yields trading at extremely low levels. Five year US treasuries, Japanese Government Bond and German Bunds are trading at 0.73%, 0.34%, 0.22%, respectively while ten year yields are trading at levels of 1.73%, 1.26% and o.6% respectively.
Global bond investors are searching for higher yields across markets leading to fall in bond yields of once shunned countries such as Spain and Italy where ten year yields have fallen by over 200bps in the last ten months. FIIs have fully taken up government bond limits of $5.5 billion that was auctioned in April and are looking to fill up the limits as soon as possible.
Domestic bond market participants have turned bullish on government bonds as seen by record high volumes. Banks, Primary Dealers, Mutual Funds, Insurance Companies and Corporates are buying government bonds on expectations of further fall in yields. RBI is doing its part for a bond rally by buying bonds through OMOs (Open Market Operations). RBI bought Rs 9650 crorein a bond purchase auction on 7 May and is expected to announce more OMOs going forward given that banks are still borrowing over Rs 100,000 crore from the RBI on a daily basis.
The risk to expectations of bond yields coming off is political. The government should not succumb to pressures of increasing spending by borrowing in an election year. If the government deviates from its stance on the fiscal deficit, bond markets will quickly take back its bullishness. The FM is quite positive of actually undershooting deficit targets and for the movement the markets will go with that confidence.