Debt Market Outlook: Term spreads remain attractive

By Suyash Chaudhary

What went by: Bonds continued their positive run with the 10-year bond yield falling by 51 basis points (bps) while the 10-year 'AAA' and 10-year SDL eased by 33 bps on the decision of the government to stick to fiscal consolidation in their FY20 budget, announcement of sovereign bond (which could help balance domestic demand/supply gap) and positive global cues.

The curve bull flattened with the 10-year to 5-year G-Sec spread reduced to 6.5 bps from 15 bps on an average in June as market participants started pricing in more easing.

The FY20 Budget surprised the market by lowering the fiscal deficit target to 3.3 per cent of GDP vis-a-vis the indicated level of 3.4 per cent presented earlier in the interim budget in February 2019. In the final budget, FY20 estimates (versus the interim budget) were cut by Rs 51,000 crore for income tax and Rs 98,000 crore for total GST collections. However, no overall expenditure cuts or higher borrowing is planned.

This reduction in revenue estimates is planned to be met by higher customs (Rs 11,000 crore), excise duties (Rs 40,000 crore), non-tax revenues (Rs 41,000 crore from higher RBI and nationalised bank dividends, possible spectrum auctions, among others) and higher non-debt capital receipts (Rs 17,000 crore from disinvestments, among others).

Furthermore, the government announced its decision to start raising a part of its gross borrowing programme in external markets in external currencies. The Finance Secretary has said first bond may take 3-5 months and that they will target borrowing 10-15 per cent of gross borrowing offshore.

India's merchandise trade deficit was broadly flat month-on-month (m/m) at $15.3 billion in June (May was at $15.4 billion). Exports fell 9.7 per cent year-on-year (y/y) in June, the weakest print since January 2016 (May was at +3.9 per cent), and imports declined 9.1 per cent (May was at +4.3 per cent), a 31-month low.

Industrial production growth for May 2019 saw a moderation in growth to 3.1 per cent from 4.3 per cent a month back and 3.8 per cent, a year ago. Economic activity-wise classification show that this moderation was largely due to the manufacturing sector which grew by 2.5 per cent.

On the user based classification, strong performance came from consumer non-durables at 7.7 per cent and infra and construction at 5.5 per cent. Growth for capital and intermediate goods remained weak at 0.8 per cent and 0.6 per cent, respectively. The durables segment has remained flat y/y.

June wholesale, or WPI, inflation further moderated sharply to 2.02 per cent (consensus: 2.25 per cent) as against 2.45 per cent in May owing to favourable base effects and moderation in manufacturing, fuel and power inflation.

In a widely expected move, the US Federal Reserve cut interest rates by 25 bps to a new range of 2.00-2.25 per cent. The Fed also announced plans to end the reduction of its $3.8 trillion asset portfolio, effective August 1, two months earlier than previously expected. In the press conference post the meet, the Fed chair described the cut as a mid-cycle "insurance" cut in order to make sure that the recovery prolongs in the face of global and trade related headwinds and also to give support to inflation.

In particular, he was focused on the cumulative change in financial conditions since early in the year during which the Fed has turned from being on a hiking cycle, to being on a patient hold, to finally cutting rates by 25 bps.

Outlook:
The RBI's MPC in its August policy cut the repo rate by 35 bps to 5.40 per cent, while maintaining the policy stance as accommodative. The move to cut was decided with the 35 bps to 25 bps vote counting as 4:2. It may be recalled that RBI Governor Shaktikanta Das had earlier floated the idea of challenging the conventional 25 bps moves, with unconventional steps like this one possibly reaffirming the signalling effect of policy direction as well.

The policy is largely in line with the dovish end of expectations. There is no decision with respect to the working group on liquidity management framework. However, the Governor did note the very large surpluses in the system today and reaffirmed the commitment to provide abundant liquidity.

Thus, the implementation basis to the recommendations of the framework is very likely to be consistent with the current market view that the RBI has already moved to targeting surplus liquidity.

With this clear stance of the current policy objective, alongside weak inflation pressures and a probable overestimation of growth, we reiterate our previously expressed view of a terminal repo rate of 5 per cent (see https://www.idfcmf.com/insights/managing-financial-conditions/), alongside provisioning of comfortable positive liquidity. With liquidity in surplus and banks' credit growth slowing, term spreads are still attractive and this remains a continued bullish backdrop for quality bonds.

(Suyash Chaudhary is Head - Fixed Income, IDFC AMC. The views expressed are personal)