Navigating Headwinds: India's Bond Market Outlook Still Positive

Bond markets are currently facing new challenges with increasing concerns on:

• External factors: 10 year UST yields up ~100 bps since first fed rate cut, INR depreciation of ~3%-4% and Crude Oil prices up by 10%


• Domestic factors: Growing deficit in banking liquidity - Core liquidity turns into deficit from surplus of ~INR 1.5 trillion.

As a result, we have witnessed significant volatility, and a 10-15 bps rise in yields across the FI curve and increased uncertainty on probable monetary policy actions.

External factors

Rising US yields

UST yields have risen by 100 bps over the last 100 days despite 100 bps of Fed rate cuts. The new President' s policies on deportation, tariffs, and tax cuts are largely seen as the reasons for the sell-off in yields. Markets expect US inflation to inch up and growth to remain strong, which has led to a rise in long bond yields and steepness in the curve.

We believe the new US president might not be able to execute all his agenda points immediately and would be slow and gradual in its implementation, as it would affect US growth and inflation negatively.

In addition, UST ? IGB correlation seems broken for the near term due to differing macro dynamics between US & India.

External factors (Contd.)

INR depreciation

Recently, we have seen INR depreciation largely on account of Dollar strengthening, FX / FPI outflows and expected slowdown in India GDP. However, India?s Macro indicators remain healthy and despite recent depreciation, INR seems to be expensive on REER basis by 3-4%.

Below table depicts Strong Macro position for India

External factors (Contd.)

Is it a repeat of 2013-14 for INR?

Although INR is depreciating, it is performing far better than EM peers. In 2013-14, INR depreciated much more than EM/ DM currencies, prompting the RBI to announce tight monetary policies.

We believe that the external situation (BoP and CAD), FX reserves and macro indicators continue to remain stable and INR needs some orderly depreciation. Hence, we do not expect any hawkish monetary policy announcements to stem INR depreciation.

Tighter monetary policies would lead to a slowdown, which can get India into a vicious cycle of slow growth, depreciating currency and higher inflation.

Oil Prices:

Oil prices saw an uptick post Biden imposed sanctions on some Russian oil tankers by ~5%. However, we expect new energy policies especially higher production and weak Global growth, to keep a lid on oil prices and do not expect any major blow up in oil prices. Despite rise in Oil prices and some rupee depreciation, we do not see any major impact on CAD or core inflation for FY 2025-26.

Domestic factors

Banking liquidity

As highlighted in our last note, ?Best of banking liquidity is behind us?, Core banking liquidity continues to see a downward trend, and has further reduced from INR 1.5 trillion in Dec 2024 to deficit. Q1CY25 is expected to see further drain on liquidity due to CIC growth, Credit growth, build up of Government balances and FX outflows.

In the last 10 years, whenever we have witnessed deficit(negative) core/ durable liquidity (E.g. 2016- 2018/19) , RBI has done core liquidity infusion of more than INR 1- 2 trillion through OMOs/ other liquidity tools.

RBI has already acknowledged the deficit liquidity situation and announced daily VRR to ensure stability in operative rate. We expect RBI to announce additional liquidity measures like VRR auctions, FX buy/sell swaps and or I-CRR cuts/ OMO purchases in upcoming monetary policy.

According to our calculations, the RBI will need to induce Core Liquidity requirements of ~INR 3- 4 trillion in 2025.

Source: RBI, as on 15th Jan 2025

Domestic factors

A substantial part of the core liquidity requirements for the year will be taken care of by the transfer of RBI dividend. By Q2CY25, we expect the RBI dividend to lead to a core liquidity infusion of INR 2 trillion. However, RBI will still have to bridge the gap of INR 1-2 trillion of Core liquidity. Hence, we anticipate RBI to announce additional liquidity measures up to INR 1-2 trillion through VRR/ CRR cuts / FX swaps in the upcoming monetary policy.

We also expect Banking liquidity to be comfortable from Q2 and operative rate to remain close to repo or below repo from Q2 post these liquidity measures.

Why does Bond market outlook look positive?

Macro variables and Positive demand-supply dynamics

Higher UST yields, depreciating INR, higher crude prices and deficit domestic liquidity can lead to near term volatility and a slower pace of RBI rate cuts. However, we still expect IGB yields to drift lower due to:

• Headline inflation had risen in the short term but is expected to fall to 4.5% next year. Core inflation continues to remain below 4% for over 12 months. We anticipate headline inflation to decrease further due to good rabi and kharif crop harvests and lower vegetable prices.


• Slowing Credit Growth and Fiscal consolidation are negative impulses for slower growth. We expect Q3 and Q4 GDP to be below 6.5%


• The Government would like to continue to adhere to fiscal consolidation (FY26 @4.5%) which will lead to positive demand supply dynamics for bonds. We do not see any major deviations in the fiscal deficit as they are targeting rating upgrades.

Snap shot of demand supply dynamics for Government Bonds

The above data indicates that supply of bonds (Gross and net borrowing) has remained flat for almost 4 years but at the same time there has been a strong growth in demand for government bonds as Real money Investor AUM base has grown substantially.

Expectations from Upcoming Budget and Monetary Policy for Bond Markets:

• Fiscal consolidation and Fiscal deficit of 4.5% with Gross and net borrowing of INR 11 trillion and INR 14.5 trillion, respectively.


• RBI may use liquidity tools to infuse liquidity of more than ~ INR 1 trillion


• Probability of RBI looking at 25 bps rate cut, or stance change to accommodative


• GDP forecast for 2025 could be lowered further to 6.5%


• We expect 10 year IGB?s yields to rally to 6.5% or below by Jun 2025

Quick Solution for navigating current headwinds

Higher engagement with Global Index providers, especially Bloomberg can lead to the addition of Indian IGB in Bloomberg Global bond. This can lead to inflows of USD 25-35 bn in Indian debt markets and can provide external sector stability.

We believe that the inclusion of India IGB into global indices can be a good solution to our current macro problems and would help in addressing core issues of currency stability, infuse core liquidity (more than INR 1.5 trillion), provide space for fiscal and monetary policy easing.

DISCLAIMER

Source & Date: Bloomberg, RBI and Axis MF internal research Date: 22nd Jan 2025

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