Huge flows likely in bond market as India prepares for inclusion in JP Morgan EM bond Index

November 18
01:09 2019

Abhishek Bisen

This year, India has cut its repo rates by 135 bps so far. The bond markets have performed reasonably well with most of the debt funds delivering double-digit returns, aside from a handful of exceptions in the industry.

Now, the questions we are left with is: Are we done with the rate-cutting cycle, and is the reversal near?

Let us try and understand the macro picture. As per the latest numbers, the headline and core inflation seem to be converging and moving to stabilise at 4 percent levels.

Brent crude is trading above approximately $ 60 a barrel, after the drone attack on the world’s largest oil refinery Saudi Aramco. This indicated a lack of demand due to a slowdown in the world economy.

As per the RBI outlook, these inflation levels are likely to continue in the coming year. This is a positive sign for the interest rate cycle.

GDP growth appears to be in a downward spiral as GDP growth for Q2 came in at 5 percent, as against an expected 5.7 percent. We believe this is likely to be even lower for the second quarter (the data will be released at the end of November).

This shows that disinflation has been created in the economy, and gradually, we may be moving towards deflation, which has already gripped one of the largest growth drivers – the real estate sector. This has aggravated the slowdown concerns in the economy.

To a very large extent, arresting inflation was for good from the long term perspective of the economy. However, as its cascading impact has started hurting the overall picture, some strong measures are needed to arrest the same before it becomes too serious.

On the fiscal side, as the economy grapples with the effects of a demand slowdown coupled with a global economic slowdown, the government recently announced a corporate tax cut, bringing down the effective corporate tax rate to 25 percent.

This move is expected to boost corporate profits and make India more competitive globally as a manufacturing hub. However, the positive impacts of this tax cut are expected to be realised over the long term. In the short term, a lot more needs to be done to prop up demand.

Liquidity in the system is in huge surplus, and the bond markets are yet to price this in. Positive liquidity can be a more important tool than the monetary policy as this has a multiplier impact.

The problem is that the yield curve is very steep which indicates the market doesn’t believe this low rate cycle is going to last longer and deeper.

As per some reports and official statements made by the government and the RBI, we believe they are serious about the transmission and will act accordingly. Thus, the curve may need to flatten to account for that.

India is also preparing for inclusion in the JP Morgan EM bond Index. This will be a huge positive for bonds and will likely see large inflows into the Indian bond market.

As global bond yields of developed markets fall into the negative zone, chase for sovereign assets is being seen, which still offers a high real rate.

The net FII/FPI investments in India have been $ 1.4 billion YTD, of which net inflows in debt amounts to $ 420 million.

Globally, interest rates are down in nominal and real terms. In fact, the developed world, where economic growth is decent, we have zero to negative real rates, whereas India is still in a very high real rates regime.

This is probably because of the fear that inflation may be coming sooner than later, which has happened in the past.

Since the core driver for inflation, i.e real estate, is quite weak, some growth revival in the sector may be needed to bring the sector out of deflation that will eventually support the economic growth.

It is often quoted that we are in a low-interest rate regime. However, the fact is that we aren’t in a low-interest rate environment. Interest rates are down in nominal terms, but not in real terms.

We are in a situation where only the government can take large measures to revive the growth and therefore, the policymakers may have to take further steps to boost the economy.

Since the government has managed the inflation well, we can afford to keep the rates lower for a much longer period of time so that its benefits can reach the last mile of the economy.

Overall, we are positive on the interest rate scenario. We believe we are likely to witness compression of spreads i.e Gilt vs AAA, and gradually will lead to compression in the sub-AAA segment over a period of time.

(The author is Senior VP & Debt Fund Manager at Kotak Mahindra Asset Management Company)

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