Banks Remain The Big Short-10Y GSec at 8.05
No Way Can Deposit Rates Get Lowered. All Blue Channel supremos backing financials will Eat Crow, when no rollovers happen at lower rates. Deposit rates will have to be raised, not reduced. This will impair Rainbow, Amrut and Uday programmes of GOI when roughly Rs 41 Tn of State Government Bonds Hit The Market. Sell All Financials...
The bond market has oddly remained under significant stress in FY2016 despite muted economic growth, benign inflation dynamics, and more important, an accommodative monetary policy. The old 10-year G-Sec (7.72% 2025) yield is ~25 bps higher than the levels seen in March 2015, despite 75 bps rate cut in FY2016. The old and new 10-year benchmark yields are now trading ~125 bps and ~105 bps higher than the repo rate respectively—as against the usual spread of ~50-60 bps. This clearly reflects a structural shift in the appetite for sovereign bonds and has disturbed the requisite monetary policy transmission (see Exhibit 1).
Structural changes in SLR-HTM norms contributing to yield hardening
We reckon that even as the change in SLR norms is a positive institutional and financial reform, the immediate repercussion has been negative for bonds. On a structural basis, sentiments have turned sour given (1) SLR requirements are progressively being reduced, (2) Hold-To-Maturity (HTM) book has been statutorily aligned with the SLR requirement, and (3) banks' MTM-related risk appetite in the Available-For-Sale (AFS) book is also tempered on fading expectations of a further rate cut, where banks are now reducing their duration on bonds.
Demand-supply mismatch likely to weigh on bond outlook
The near-term risks to G-Sec outlook could be a larger-than-expected fiscal deficit, which will further push up the borrowing costs both on account of credibility and worsening the demandsupply mismatch in the bond market (see Exhibit 2). We estimate that with FY2017 GFD/GDP of 3.5%, the gross G-Sec borrowing could amount to ~`6.3 tn, ~10% higher than FY2016, although net borrowing will be marginally higher. The net SDL borrowing are expected to increase substantially by ~13%, partly on the back of higher interest payment on special SDLs, converted from bank loans of discoms under the UDAY program. Overall material increase in total bond supply would imply a demand gap of ~`600 bn. Further shift in institutional investors' proclivity towards high-yielding special SDLs could worsen this gap. This may result in further widening of SDL spreads—recent higher SDL auction cut-offs being precursor to the likely eventuality of aggravating pressures.
OMOs remain the most effective savior for bonds
OMOs continue to be the primary source of respite for bonds. To the extent that BoP surplus is muted and domestic liquidity remains tight, RBI will be prompted to create base money via OMOs, which could alleviate G-Sec imbalances. Other factors that may help yields at the margin in the coming months include (1) a positive fiscal surprise (sticking to GFD/GDP of 3.5%), to the extent that some fiscal relaxation is priced in, (2) 25-50 bps rate cut in CY2016 amid favorable growth-inflation dynamics and monetary accommodation in the rest of EM Asia, and (3) net increase in global liquidity, helped by ECB and BoJ's additional QEs in early CY2016, which should chase attractive carry that India offers (especially when UST 10-year yield has now plummeted to ~1.73%). This, however, will be subject to stability in global risk sentiments
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