Why the rally in government securities is not over

There has been an interesting disconnect between the global and Indian business cycle over the last two years.

While the rest of the world, particularly the western central bankers, have steadfastly focused on reviving growth since 2011, India has been caught in a strange dilemma between high inflation and elevated current account deficit (CAD) on the one hand and a significant growth slowdown on the other. No wonder our central bank has adopted a cautious and calibrated approach over the last 18 months.

Typically, slowdown is the best medicine for all macro risks, as economies tend to correct excesses or imbalances automatically.

A growth slowdown is generally the automatic response to high inflation or high CAD. Central bankers typically pre-empt high inflation or CAD and try to moderate growth by making money pricier. The RBI did the same to tackle these risks, though many argue that the response was delayed and slow.

As India struggled with this non-textbook, macro-economic environment in mid-2012, we spotted an opportunity for significant bond rally in India and predicted that the 10-year government bond would hit a hit of 7.5 per cent. Now that we have seen a 60 basis point fall in yields since we wrote the note, and are within striking distance of 7.5 per cent, it is appropriate to look beyond.

Big bond rally

We think India is at the beginning of the next big bond rally. We expect 10-year gilt to breach 7 per cent levels by the end of the current rate cycle. This is based on a detailed look at five factors: growth-inflation dynamic, demand-supply technicals, liquidity situation, credit, and security specific factors.

While the consensus on FY13 GDP stood at 6 per cent when we released our last note, we were among the very few expecting a lower 5-5.5 per cent rate of growth. We may now end up witnessing a growth of 5 per cent for FY13, the lowest in a decade.

We expect FY14 GDP to remain low at 5.5 per cent (with a downside bias). The slowdown over the last 24 months is likely to remain protracted in the absence of any turnaround in the sluggish investment scenario, which is unlikely this fiscal.

While growth is expected to remain subdued, the silver lining in India’s macro story is offered by the likely decline in headline inflation. If ‘low growth, high inflation’ haunted us for quite some time, it now looks likely for inflation to follow the declining trend in growth. For FY14, we expect WPI to moderate to 5.5 per cent from 7.4 per cent in FY13.

Once inflation is tamed, the other villain threatening macro-economic stability is the ballooning CAD.

Just like inflation, CAD was another counter-intuitive part of the Indian macro story whereby, despite continuous growth slowdown, our CAD worsened from 4.2 per cent of GDP in FY12 to about 5 per cent in FY13.

But, looking ahead into FY14, we expect CAD to moderate to 3.5-4 per cent largely due to a moderation in our net oil imports, some improvement in the non-oil, non-gold trade balance, and rupee remaining stable at current levels.

Possible scenario

A macro-economic scenario characterised by low growth, moderating inflation and receding CAD should eventually pave the way for the RBI to become more responsive to the current growth slowdown.

In order to arrest the slowdown while risks of inflation remain under check, we expect the RBI to cut repo rate by another 75 basis points this fiscal.

To top it all, we expect that with a change in guard, the RBI’s view on liquidity and rates are likely to become more benign and the entire thesis of maintaining liquidity deficit in an anti-inflationary stance would undergo an ideological change.

Thus, we expect the RBI to leverage multiple tools to ease liquidity such as mopping up dollar flows, open market operations and CRR cuts through FY14 and FY15. All this should translate into an additional effective easing of 175 basis points in the current rate cycle, where we expect middle of the corridor to become the operative rate. As a result we expect terminal repo rate to fall 6 per cent by the end of this cycle. We believe the 10-year gilt yield will fall from the current 7.7-7.8 per cent levels to within 7 per cent within one year. Moreover, we believe that there is a good case for SDL and corporate bond spreads to tighten further going into FY14 as high quality assets will remain well bid.

Durable or not?

Will low rate regime be durable? I think the answer to this lies in the state of corporate balance sheets and increased stress in banks books. The RBI had ensured a low rate regime during 2001-03 to stimulate investment from corporates and heal the balance sheets of banks which came under severe pressure due to protracted slowdown.

In the past couple of years, there has been a similar leverage increase in corporate balance sheets and consequent stress which is manifested in elevated bank delinquencies. All this strengthens the durability of the rate reduction cycle.

But of course, like any other proposition, our hypothesis too is subject to some risks. A key risk that may alter our view is the uncertain political scenario that may result in early general elections. Any such advancement of elections may force the RBI to halt the rate easing cycle as the Government recalibrates its fiscal framework and its response to critical policy concerns.

Nonetheless, if everything pans out as we have envisaged, we may be setting the stage for a brand new business cycle, as important conditions for sustained recovery such as low rates, low inflation, substantial cumulative output gap and an active government are falling into place.

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