Bond markets troubled by fiscal, monetary pains

Budget FY19 triggered a sell-off in the Indian bond markets last week. The 10-year INgov yield rose 20-30 bps to more than 7.60 per cent; it was flat, mostly around 7.20-7.40 per cent, for most of January. Optimistic revenue projections and concerns over the inflationary impact of budgetary measures weighed on sentiment. Higher fiscal targets for FY18-19, along with rising oil prices, are set to make the Reserve Bank of India’s (RBI) policy path a tricky one this year.

Challenging aspects of the budget

After an encouraging track record of fiscal consolidation in recent years, the FY19 budget was a mixed bag on three counts. Firstly, the outgoing fiscal year marked fiscal slippage. The government revised the FY18 fiscal deficit target to 3.5 per cent of GDP (vs targeted 3.2 per cent) and FY19 to 3.3 per cent (the medium-term fiscal roadmap had envisaged a deficit of 3 per cent of GDP). In capping the deficit at FY17’s 3.5 per cent, this slippage was viewed as a pause rather than a reversal in the consolidation process. Even so, the decision to push back the 3 per cent deficit target by two years to FY21 amidst higher minimum support prices for farm produce was still perceived as negative. Equity markets have also been depressed by the government’s move to reinstate the long-term capital gains (LTCG) tax on investments (despite the grandfathering provision).

Pay attention to the credibility of the fiscal math. For a start, the 11.5 per cent nominal GDP growth assumed (vs 10.5 per cent in FY18) appears reasonable, assuming a 7-7.5 per cent real GDP growth and implicit GDP deflator of ~4per cent. We, however, find the FY19 revenue projections optimistic, given the shortfall from lower GST-related and non-tax receipts.

Hinging on an improving growth outlook, the government is banking on a notable pick-up in collections. Gross tax revenues have been forecast to improve by 0.5 per cent of GDP in FY19 amidst a moderation in non-tax revenues and non-debt receipts (divestments). In contrast, plans to lower overall expenditure outlays by 0.2 per cent of GDP may be unrealistic due to the busy political calendar year ahead. Interest payments (likely due to the recent rise in borrowing costs) and subsidies (on higher food and fertiliser allocations) are also projected to rise next year.

The overall fiscal impulse, inferred from the primary deficit (excluding one-off revenues), is mildly contractionary. Adhering to this path implies a smaller government role in lifting growth, with the onus on the rural/farm sector to spur consumption.

The bond market’s nervousness over the impending demand-supply imbalance is understandable. The supply pipeline will be busy under the FY19 borrowings plan; gross market borrowings are set to rise to Rs 6.1 trillion from Rs 5.8 trillion in FY18 (excluding T-bills). On the demand side, banks are already holding more bonds than required for maintaining their statutory liquidity ratio (SLR) while foreign institutional investors are holding the maximum amount of government bonds allowed. Both parties have suffered mark-to-market losses in their investment portfolios from the recent bond market volatility. Concurrently, banks’ credit growth has picked up amidst slow deposit growth, providing banks with little incentive to lock up funds by increasing bond purchases.

Expect the RBI, at its next monetary policy review on Wednesday, to factor in the projected fiscal slippage. The combination of fiscal challenges and rising oil prices makes the RBI’s policy path a tricky one this year. Growth has largely bottomed out, but India is yet to benefit from the synchronised pick-up in global demand. In this light, we expect the monetary policy committee to turn hawkish, but not enough for the balance to tip towards a rate hike this week. While the modest cut in the fuel excise duties will help mitigate the pressure from higher oil prices, the RBI will closely watch the spill-over from the proposed minimum support prices (MSPs) into rural/farm wages and, by extension, demand conditions. This will, however, be hard to quantify due to scant details.

In the past, a sharp increase in MSPs has led to high food inflation and generalised price pressures. For now, the RBI will flag the projected fiscal slippage, higher oil, and MSPs as risks to future inflation, but not as factors that warrant an imminent tightening.

This week, RBI may also communicate its intention to lift its inflation estimates as well as revise down its GVA (gross value-added) growth forecast for FY18. For now, we are retaining our base case for an unchanged policy bias in 2018 based on our assumption that inflation will moderate towards 4 per cent in H2 2018. Even so, we acknowledge that the odds for rate hikes to be brought forward to H2 would rise if inflation proves sticky around 5 per cent from the MSPs and persistently higher oil prices.

The recent widening of 10Y yields-repo rate spreads (to 2013 levels) also partly reflects higher risk premia apart from tighter policy considerations. Notably, other markets-based borrowing costs; short-end certificate of deposit rates, banks’ lending rates etc., have also tightened in recent weeks. A hawkish commentary from the RBI will put a floor under these rates. Apart from its policy guidance, the central bank has a preferred non-interference stance that implicitly requires banks to manage their own interest rate risks.

In Asia, Indian government bonds have been the worst performers over the past three months as the market grapples with multiple worries -- from India’s fiscal slippages to rising oil prices to a faster-than-expected rise in UST yields. Two-year and 10Y Indian yields are up by 33 bps and 24 bps, respectively, since the start of the year.

Pessimism in the bond market started initially last year from a selloff in the longer tenors as issuance risks weigh. This extended to the front of the curve early this year amid a sharp tightening in liquidity. Notably, the 3M interbank financial reference rate pushed above 7 per cent even as the repo rate was kept unchanged at 6 per cent.

Typically, the spread between these two rates tends to be much closer to 25-30 bps when liquidity conditions are flush. We have revised our 2Y and 10Y yield forecasts to 7.1 per cent (from 6.6 per cent) and 7.9 per cent  (from 7.55 per cent), respectively, by the end of 2018. On balance, we think the authorities will take steps (bond purchases through open market operations, inject liquidity into the system and raise FPI investment) to smoothen out yield increases. Thus, we expect bond yields to head higher from current levels, but at a moderate pace over the coming year.

Tactically, we prefer shorter-tenor bonds. While we have shifted our 2Y yield forecasts higher (to take into account the possibility that rate hikes may come early), we suspect that high short-term yields are really driven by tight liquidity. Should liquidity conditions ease, the total return over a year for shorter-term bonds should still be very attractive.