Informist, Tuesday, Mar 5, 2024
By Nishat Anjum
MUMBAI – The market has largely failed to factor rate cuts into short-term government bonds with maturities of up to five years as yields on these papers have hovered close to the yield on the 10-year benchmark gilt. Bond investors say they need more certainty on domestic liquidity conditions and rate cuts in the US before they add more of these securities, considered the most rate-sensitive, to their portfolios.
So far in 2024, the yield on the 10-year benchmark bond has fallen 12 basis points to the current 7.06%, while the yield on the five-year benchmark bond has inched 1 bp down to 7.06%. On a closing basis, India's yield curve between these bonds has been flat since Feb 13. Typically, in a normal yield curve, the five-year and 10-year benchmark papers trade with a spread of around 25 bps.
The key reason for the flat yield curve is that while market participants agree that rate cuts will take place in India in 2024, they remain divided on the timing and extent of monetary easing. Traders have a staggered timeline as to when short-term bonds will fall and the yield curve will normalise, even as the current consensus reflected in overnight indexed swap rates suggests a rate cut no earlier than October. The five-year bond would trade 15-20 bps lower than the benchmark 10-year paper if it reflected rate-cut expectations, gilt dealers said.
One set of dealers says overnight rates falling to 6.50% and staying there will open the door for traders to bet on rate cuts in India through these bonds. The other view is that even if the Reserve Bank of India is unwilling to ease liquidity conditions, a rate cut by the US Federal Reserve will be hard to ignore and will pull short-term yields lower. Currently, it is only in June that a majority of Fed funds traders expect at least a 25 bps rate cut, according to the CME FedWatch Tool.
Rate-cut expectations in the world's largest economy have not only been pushed back to June from March, but they have also been slashed in half. Traders in the US now expect only three rate cuts amounting to 75 bps in 2024, rather than six or 150 bps earlier. These expectations are in line with the Fed’s dot plot projection. The current target rate is 5.25-5.50%.
"There is no visibility on the rate cuts. There is only hope that it is going to be sometime in H2 (Oct-Mar)," a senior treasury official at a state-owned bank said. "There will be no visibility till either liquidity improves or the Fed starts cutting rates."
A Fed rate cut is widely seen as a pivot point for domestic monetary policy. Even if the liquidity in the banking system eases as government spending picks up, the domestic rate-setting panel is unlikely to move ahead of the Fed, treasury officials said. The RBI would rather seek to bring the overnight rate to 6.50% on a sustainable basis, which would be a reversal of a proxy rate hike of 25 bps from the high overnight rates persisting since August, gilt dealers said.
Optimists on the liquidity front expect the short-term bond yields to correct as the government spends its cash balance and the new supply for 2024-25 (Apr-Mar) kicks in. If, like in the previous two fiscal years, the government borrows mainly through long-term bonds, this, coupled with ease in liquidity, may prompt the yield curve to steepen between the two- and 10-year maturities, dealers said. They expect a correction of 10-15 bps in short-term bond yields.
However, the spread between short- and long-term bonds may not return to normal. Dealers expect robust demand for long-term bonds to continue in the new fiscal year as well, spearheaded by insurers and foreign portfolio investors after India's inclusion in JP Morgan's bond indices in June. This would also keep a cap on any rise in long-term yields, which have anyway been the pick of the pack for discretionary investors such as mutual funds. The dealers expect the yield curve to bull steepen-–a situation when short-term yields fall markedly more than those of longer tenures, widening the spreads between such paper--only when either the RBI's Monetary Policy Committee indicates it is close to cutting rates, or the Fed slashes interest rates in June.
Not only have volumes of rate-sensitive short-term bonds remained low in the secondary market, the movement in short-term bond yields has also been lacklustre despite rate-cut expectations being pushed back in India. While the overnight Mumbai Interbank Offered Rate has fallen to the policy repo rate of 6.50% sporadically since February, it has not stayed there.
At the end of trade on Monday, the liquidity surplus in the banking system was 409.02 bln rupees, the highest since Sep 11, against a deficit of 1.56 trln rupees at the end of December, data from the RBI showed. Despite easier liquidity conditions in recent weeks, the overnight MIBOR has fallen below the marginal standing facility rate on just 10 days since January.
The RBI has been more nimble with two-way liquidity operations, but these have only consisted of variable rate repo and reverse repo auctions so far. This has created more short-term volatility, because banks' ability to trade on underlying liquidity gets disrupted by these short-term and sometimes multiple liquidity injections or mop-ups in a day by the central bank, dealers said. Traders have read this as a sign that it is too early to factor rate cuts into short-term government securities beyond the 91-day Treasury bill.
"The government has to spend the remainder of its budgeted amount in March, so durable liquidity will no doubt improve and help the short-term yields come down," Mayank Prakash, deputy head of fixed income at Baroda BNP Paribas Mutual Fund, said. "But it's crucial that rate cuts in the US are certain. By March-end, we should also have enough data points to show that the US will definitely begin cutting rates."
Given there are five more Fed policy meetings before the Monetary Policy Committee's October review, the market fears getting its fingers burnt, as they were when hopes of a quick pivot first took hold in Apr-Jun last year. Rate-cut expectations in the US have see-sawed so rapidly that traders are not comfortable maintaining the same pace back home, dealers said. Moreover, long-term bonds are a surer bet for investors with demand expected to exceed supply in 2024-25, and yields moving directionally lower due to potential rate cuts, offering higher capital gains.
The view that rate cuts in India will only begin in the December quarter is also backed by the robust growth of the economy and by headline CPI inflation, which is projected to remain above the RBI's target of 4% even in Oct-Mar. In such a case, the domestic rate-setting panel will not have much motivation to change its policy stance or cut rates, dealers said.
In a more active market, the divided views may have led to greater trading volumes. The optimists are hoping for a steepening of the yield curve by late March, while the pessimists are not seeing meaningful opportunity in short-term bonds at all in 2024-25. With convictions low for either scenario and bond portfolios chock-full of gilts, all bets will likely stay on hold.
For the market to bet on rate cuts through short-term bonds, it either needs clarity from the RBI on the liquidity front or the Fed to move ahead with a rate cut. Unless either of these events unfolds, it is possible that short-term bonds will not see much traction, gilt dealers said. When these central banks will make their move is anybody’s guess. End
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