Despite decline in Govt bond yields, investors should remain cautious

The RBI substantially lowering its inflation projection, indicating continued open-market operations and hinting at a long pause in rate action, has lent cheer to bond markets. The yield on the 10-year G-Sec has fallen to 7.4 per cent from 7.6-7.7 per cent. But the Christmas cheer could wane and, hence, investors need to remain cautious in the months ahead.

Risks to fiscal slippages and upside risk to RBI’s inflation projection are likely to cap the gains in the coming months. A sudden reversal of food prices, sticky core inflation, persisting uncertainty over crude prices, and upward revision in the government’s borrowing calendar for the last quarter of this fiscal, could play spoil sport.

Moving parts

Until September, concerns over inflation, tightening global liquidity, and the RBI hiking its key repo rate had led to a rise in interest rates. In fact, G-Sec yields had peaked at 8.1 per cent in September before falling to 7.7 per cent levels over the last two months.

The RBI bringing in measures to ease liquidity, coupled with announcement of several open-market operations (buying of government bonds of ₹36,000 crore for the month of October 2018 and ₹50,000 crore for November 2018), had soothed the bond markets in the past month or so.

The RBI’s policy on Wednesday has cheered bond markets further. The central bank has substantially lowered its inflation projection for the second half of the fiscal (from 3.9-4.5 per cent to 2.7-3.2 per cent), indicating a long pause in rate action. This, along with the fact that the RBI will continue to do open-market operations, has lent relief to bond markets, but there are several risks to the optimism.

Various data points throw up mixed signals on the direction of interest rate movement over the next year.

CPI inflation fell unexpectedly to a low of 3.3 per cent in October from 3.7 per cent in September. This was led by food inflation, which was at a negative 0.14 per cent, driven by a sharp fall in vegetable inflation at 8 per cent YoY, and pulses at 10 per cent.

But it is on a high base that vegetable prices have been very sedate this year. As of November-end this year, tomato and onion prices have fallen by over 50 per cent over last year.

Whether such sharp fall in food prices will sustain remains to be seen. However, as the base effect wears out, food inflation is most likely to trend up next year. The RBI, too, in its policy, has highlighted the risk of sudden reversal in food prices.

In any case, sticky core inflation (excluding food and fuel) over the past year remains a concern. Core inflation moved up to 6.1 per cent in October from 5.8 per cent in September.

Household goods, health and transport have moved up notably. Hence, core inflation could continue to exert upward pressure on overall inflation numbers.

Then there are fiscal worries to reckon with. The fiscal deficit has reached 103 per cent of the target up to October. While direct tax collections are healthy, it may not be enough to make up for the shortfall in GST collections and non-tax revenues.

Hence, an upward revision in the government’s borrowing calendar for the last quarter of this fiscal, may impact bond prices adversely.

The RBI’s staggered SLR cut (essentially lowering of demand for government bonds) announced in the policy, may, however, not adversely impact bond yields, as banks already hold in excess of mandated SLR requirement – about 28 per cent of deposits as against the mandated 19.5 per cent.

Bottomline

Given the uncertainty over various factors impacting bond yields, bond investors must cap their expectations and tread with caution. While the yield on the 10-year G-Sec may hover around current levels in the interim, hardening of yields over the next six months cannot be ruled out.

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