- Fiscal arithmetic for FY2016 remains comfortable though FY2017 Budget is in focus as fiscal dynamics appear challenging on implementation of the 7th Pay Commission (7PC).
- While we maintain our post-Budget rate cut call, bar for the same has been raised higher in the light of 7PC.
- Fundamental support to gilts is muted and sentiment is likely to remain cautious ahead of the Budget.
Dampened risk sentiment supported global bond market rally Since the start of new year, markets have been rattled with falling crude oil prices, volatility in Chinese stock markets, structural slowdown in China and geopolitical tensions. Consequently, a rally in DM bond markets was seen with UK and US bond yield falling by more than 20 bps in last 2 weeks.
Fiscal and inflation uncertainty have raised the bar higher for further rate cuts December-2015 CPI edged up to 5.6% YoY versus prior of 5.4% YoY on account of an unfavourable base effect. Further, the elevated pulses and vegetables CPI is a cause for concern though Government measures are likely to lead to some correction in the coming months.
Going forward, we expect the RBI's Jan-2016 5.8% YoY CPI projection to be comfortably achieved. In FY2017, while 7PC is likely to adversely affect housing CPI, the underlying trend for CPI ex housing is expected to be closer to RBI's 5% target on weak commodity prices and demand conditions. However, the implication of 7PC on fiscal roadmap may act as a deterrent towards monetary easing. On balance, while we maintain our post-Budget rate cut call, bar for the same has been raised higher in the light of 7PC.
Liquidity to deteriorate in Q4; room open for OMO purchases The liquidity situation is expected to witness seasonal deterioration in Q4 FY2016 on account of buildup in Government balances and increase in currency in circulation. Meanwhile, we expect liquidity situation to receive support from 3 factors: (1) Debt buyback of ~INR 300 bn, (2) OMO purchases worth ~INR 200-250 bn and (3) FX intervention of ~INR 450-500 bn. On balance, systemic liquidity deficit is projected at ~INR 1300 bn –INR 1400 bn by end Q4.
Yield likely to continue to steepen Recent months have witnessed a relatively higher pressure on longer end of the yield curve vis-à-vis shorter end on account of - Higher demand for low duration Gsec: The RBI's demand for bonds in the form of open market operations has been concentrated in shorter dated securities.
- Expected rise in supply pressures: In the next fiscal, assuming that the government adheres to the roadmap and budgets the fiscal deficit at 3.5% (of GDP), net borrowings are likely to decline. However, gross borrowings are expected to increase above INR 6 tn levels (after accounting for debt buy back worth INR 300 bn). Further, the duration of supply issuance is likely to continue to increase in order to adjust for heavy redemption pressures in coming years.
- Reduced probability of further policy easing: As witnessed in the historical past, yield curve steepens sharply as investors perceive a near end to the monetary accommodation cycle.
Fundamental support to gilts is muted and sentiment is likely to remain cautious ahead of the Budget. Markets could come under further pressure on an increase in global market volatility. Meanwhile, OMO purchases are expected to provide some support. On balance, we expect the new 10Y bond yield to trade in a range of 7.50-7.75% in the near term.
Yield curve has steepened sharply 
Source: Reuters', ICICI Bank Research
Supply pressures likely to remain elevated in the next fiscal 
Source: Budget documents, ICICI Bank Research
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