Last hurrah for the bond-bulls?

News on the stock-market indices might have dominated the headlines but the less visible and somewhat mysterious (to many) bond markets have also seen a bull run. Bond prices are inversely related to their yields and so a fall in yields captures a rise in prices. The yield on the 10 year benchmark index has dropped from around 6.9 per cent in February this year to 6.45 per cent in July, a hefty capital gain. Given this run-up in prices, it might be sensible to ask the same question that is being increasingly asked for stocks. Will this rally last?

To answer this, a quick recap of recent history is useful. For the bond markets the first six months of 2017 produced a raft of surprises. The mother of these surprises was perhaps the RBI’s decision in its February monetary policy to change its stance from ‘’accommodative’’ to neutral when the market participants almost to the last man expected a rate cut to compensate for the disruption caused by ‘demonetisation’. The RBI justified its unexpected behaviour on the ground that the disruption would be temporary and argued that inflation would over time become a problem. This led to a sharp dip in bond prices and yields rose. As a large number of risks confronted the markets — the monsoon, oil dynamics, GST structure, the new US president’s policy agenda on emerging market assets, bond investors seemed to have told themselves – ‘the central Bank must know something that we don’t’(a common syndrome when markets are caught on the wrong foot).

The April policy, too, came as a bit of a shock. Market participants expected a status-quo on all policy rates but the RBI went ahead and hiked the ‘reverse repo rate’ (the rate that the RBI offers banks when they park surplus cash with it) so as to ensure “finer alignment of the weighted average call rate” with the principal policy rate – repo rate. The net result was a rise in both short term and long term rates.

However, from April headline inflation numbers started coming in well below what the RBI had provided in its earlier guidance and also below what professional forecasters had pencilled in. Pulses and vegetable prices had collapsed on the back of massive oversupply. The bond markets finally got its prediction right for the June policy. While only few expected the central bank to actually cut its signal rate there was consensus on the fact that the RBI would tone down its hawkish rhetoric on inflation. The RBI played ball with a sharp downward revision of its inflation forecasts (from 4.7 per cent to 3.3 per cent for 2017-18) paving the way (or so the majority of market players believe) for a repo rate cut in the monetary policy due on August 2. These developments brought the benchmark bond yield down by around 30 basis (a basis point or bp is one hundredth of a percentage point) over the last two months.

Clearly, there is a strong case for a rate cut in August and if the RBI disappoints, the bond rally could become a rout. However post the August policy, market movement will dependent critically on both inflation expectations and movements for the second half of the fiscal. In this regard, it is important to understand that major part of the recent collapse in food prices is cyclical and hence temporary. While prices of pulses for example are unlikely to spike in the near future and will continue to remain low this year, the medium-term trajectory is still uncertain. If they do follow their usual cyclical pattern, prices will tend to harden as we go into the next year and the RBI could factor this in forming its view.

Bond bulls point to the fact that food prices are not the only contributor to the inflation decline. The closely watched core inflation number (shorn of cyclical elements like food and fuel) has also declined. It remains to be seen how the RBI views this fall since roughly half of the ‘core’ items remain sticky. In any case as the effect of ultra-low food prices fades and statistical factors like the base effect turn adverse, inflation is set to rise.

Another red flag for the bond markets is the likely deterioration of State finances. States face serious fiscal challenges principally from pay hikes for government employees and the series of farm loan waivers announced recently. As yet bond investors do not appear too perturbed by this. Pay hikes are likely to be staggered over the next couple of years. For example, Gujarat, Haryana, and Himachal Pradesh budgeted for it in the last fiscal year and for Maharashtra and Jharkhand, the pay outs could be deferred to 2018-19. Meanwhile, Andhra Pradesh, Kerala and Telangana follow their own cycles and the next review for them is due in 2019.

Besides we believe that States could find alternatives to borrowing directly in the bond markets in order to finance farm loan waivers. Transferring special bonds (UP floated the idea of Kisan Rahat Bonds) to banks is a possibility. States would pay interest on these loans while deferring principal payments. However there is perhaps a limit to which financial engineering can stave off the impact of what is clearly a major fiscal lapse for States.

Global monetary tightening is another risk that looms on the horizon and could offset the easy domestic liquidity regime. The US Fed appears to be less aggressive than in the past but some more rate hikes are due. Combine this with the possibility of both the European and American banks lightening their overstretched balance sheets (the result of sustained quantitative easing) by selling bonds and you get a scenario where global impulses push up rates.

What is the upshot then? In the near term, a rate cut from the RBI and another good inflation print are likely to keep bond yields depressed or support a mild uptick in bond prices from current levels. However if the RBI sounds very cautious and flags impending risks, which we believe is the most likely scenario, it could set a floor to bond yields. A sharp spike in yields is unlikely but the markets might swing between expectations of another cut (if inflation does print below predicted levels) and anxiety over rising domestic debt ( the States’ fiscal position) and global risks. If in the unlikely event that the RBI sounds particularly soft on inflation and the odds of a rate cut rise post-policy, the current rally could sustain.

Arora and Barua are Senior Economist and Chief Economist, respectively, at HDFC Bank. Views are personal

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