Debt Market Review

Mr. Avnish Jain
Head - Fixed Income

Fixed Income Market Outlook
Global Economy Update:

The global economic and financial environment has deteriorated with the combined impact of monetary policy tightening across the world and the persisting war in Europe heightening risks of recession.
Gripped by risk aversion, global financial markets have experienced surges of volatility and large two-way movements. The US dollar index soared to a two-decade high in July. Both advanced economies (AEs) and emerging market economies (EMEs) witnessed weakening of their currencies against the US dollar. EMEs are experiencing capital outflows and reserve losses which are exacerbating risks to their growth and financial stability.
Global Financial Markets:
U.S. equity markets rose initially during the month under review amid reports that the U.S. President may announce a rollback of some U.S. tariffs on Chinese imports. Upbeat U.S. jobs data for June 2022 also contributed to the upside. Market sentiments were further boosted after the U.S. Federal Reserve chief indicated that the pace of rate hikes may slow down in the upcoming months once inflation peaks out in U.S..
Asian equity markets closed on a mixed note in July. Markets initially remained under pressure after data showed that China's economy grew at the slowest pace in the second quarter of 2022 since the start of the COVID-19 pandemic. However, markets later received some support after People's Bank of China kept its benchmark lending rates unchanged as expected and the U.S. Federal Reserve Chief indicated in its monetary policy review that it may slow down the pace of rate hikes in the upcoming meetings.
Indian equity markets went up in the month of July 2022 with Nifty 50 growing by 8.73% m-o-m basis majorly led by fall in global crude oil prices and a rebound in foreign fund inflows in the domestic equity market. Upbeat domestic corporate earning numbers for the quarter ended Jun'22 also contributed to the upside. Foreign Institutional Investors (FIIs) were net buyers in Indian equities to the tune of INR 4,988.85 crore in July 2022. In the bond markets, the U.S. Treasury prices rose during the month after review on growing possibility that the U.S. Federal Reserve might slow down the pace of rate hikes moving ahead amid growing fears of a recession. The FED chair, Mr Jerome Powell, pointed out in his press conference, post the Federal Open Markets Committee (FOMC) meeting, that “as the stance of the monetary policy tightens further, it will likely become appropriate to slow the pace of increases while we access how are cumulative policy adjustments are affecting the economy and inflation”. This led to market repricing the terminal rate for FED funds rate and possible reversal of policy in late 2023.
Domestic Economic Growth:
In a global landscape marred by fears of recession and war, the Indian economy shows resilience. The recent revival of the monsoon, the pick-up in manufacturing and services, stabilisation of inflation pressures and strong buffers in the form of adequate international reserves, sufficient food grain stocks and a well-capitalised financial system together brighten the outlook and strengthen the conditions for a sustainable high growth trajectory in the medium-term. The Indian economy is showing resilience and dynamism in spite of the geopolitical situation and high-risk aversion in financial markets that is stampeding portfolio investors and taking down all currencies against the unrelenting strength of the US dollar. Apparently, markets are differentiating between currencies on the basis of the size and speed of monetary policy tightening relative to the US Fed. In comparison with peers, the depreciation of the INR has been modest at 5.1 per cent on a financial year basis and 7.0 per cent on a calendar year basis to date..
High frequency indicators of activity in the industrial and services sectors are holding up. Urban demand is strengthening while rural demand is gradually catching up. Merchandise exports recorded a growth of 24.5 per cent during April-June 2022, with some moderation in July. Non-oil non-gold imports were robust, indicating strengthening domestic demand. Resilient demand has translated in a sharp rise in imports in July 22 which led the trade deficit to jump sharply to USD 31.02 billion pushed higher by crude oil and coal imports.
Goods and Services Tax (GST) collection shows that INR 1.48 lakh crore collected for Jul'22, which is 28% more than the corresponding period of last year and is second-highest monthly total. GST collection has crossed Rs 1.25 lakh crore mark for the tenth consecutive time, providing relief on the fiscal front.
Inflation:
India's inflation is on the backfoot. For the second month in a row in June, headline CPI inflation eased in India. The y-o-y Consumer Price Index (CPI) inflation print for June 2022 was 7.01 which was lower than the previous two months. (7.04% in May'22 and 7.79% in Apr'22). Headline inflation has recently flattened, and the supply outlook is improving, helped by some easing of global supply constraints. The monetary policy committee (the MPC), however, noted that inflation is projected to remain above the upper tolerance level of 6 per cent through the first three quarters of 2022-23, entailing the risk of destabilising inflation expectations and triggering second round effects. Given the elevated level of inflation and resilience in domestic economic activity, the MPC took the view that calibrated monetary policy action is needed to contain inflationary pressures, pull back headline inflation within the tolerance band closer to the target, and keep inflation expectations anchored so as to ensure that growth is sustained.
RBI Monetary Policy Update (August 5, 2022):
The monetary policy outcome was at higher end of expectations with the monetary policy committee (the MPC) hiking repo rate by 50bps to 5.40%. In past few days, rate markets had rallied with 10Y touching a low of 7.11% at start of the MPC announcement, on expectations that considering the global concerns on recession in advanced economies (AEs), the MPC may indicate less aggressive policy stance. With focus on bringing down inflation to MPC's range on 2%-6%, the committee continued to provide guidance of “to remain focused on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth.”
The MPC continues to focus on inflation and with pressure on currency continuing, in face of strong dollar, elevated commodity prices as well large FII outflows since start of 2022, normalization of ultra-accommodative pandemic policy is likely to continue, till the MPC believes that the rate is in a restrictive zone. The MPC retained growth forecast for both GDP as well CPI inflation at 7.2% and 6.7% respectively. The committee noted the recent incipient signs of factors that could lead to softening of inflation, but considerable uncertainties remain. Hence, the MPC believes that with expectations of growth momentum sustaining despite strong headwinds, continued adjustment of monetary policy is required to move towards medium term target of 4% inflation. The MPC is likely to continue its calibrated hikes in next few policies, with possibility of the reduction in quantum of hikes to 25bps, as 3 large moves have been frontloaded. Markets had been in an exuberant mode expecting in run up the policy, expecting some positives outcomes. However, the MPC chose to stick to path of rate hikes in light of above trend inflation as well as pressure on the external sector. After touching low of 7.11%, the 10Y climbed sharply back to 7.24%-7.26% (currently). Yields may rise a more as markets adjusts to the reality of continued policy tightening in foreseeable future.
Bond Yields & Spreads:
In the fixed income market, bond yields eased tracking decline in the U.S. treasury yields and gains in the Indian rupee as on July end. However, gains were limited following rise in global crude oil prices. Yield on the 10-year benchmark paper (6.54% GS 2032) inched down by 1 bps to close at 7.32% as on July 29, 2022, as compared to the previous close of 7.33%.
Overall, the yield curve is indicating an improvement in long-term growth prospects, an upshift in ex ante inflation expectations and tighter monetary policy in the period ahead.
Corporate bond yields softened in tandem with the G-sec yields across tenors and the rating spectrum. Credit risk premium as reflected in the spread of corporate bond yields over G-sec yields of equivalent maturities also declined marginally during the same period. Consequently, corporates were deterred from raising funds in the bond market, with primary market issuances during 2022-23 so far (up to May 2022) remaining tepid at 0.33 lakh crore.
Fixed Income Market View:
The sharp concurrent tightening of financial conditions in AEs is leading to a belief of hard landing in the US as well in other advanced economies. The recession concerns have led to softening of yields, as markets believes systematically important central banks, like the US Federal Reserve, may be compelled to change direction on tightening, if faced with recessionary trend. Inflationary pressures continue to remain in the US, with labour market continuing to remain strong, despite 225bps of tightening since March 22. The latest labour data shows unemployment rate at 3.5%, remaining near the 50year lows. The FED is committed to bring inflation down and is likely to continue to tighten rates till the labour market shows signs of softening, possible pushing the US economy into a recession.
Indian bond market benefitted from changed global sentiment as well correction in oil prices from their highs. Government taking steps to quell inflation via reduction in duties and ban on exports of wheat etc, added to market positivity. However, RBI chose to frontload rate hikes with a 50bps move in August 22 policy. This may have been done as external sector continues to remain under pressure from a strong dollar as well FII outflows. Softening oil prices may provide some relief.
Evolving global cues relating to geo-politics, US rates, and commodity prices, would likely continue to drive Indian markets. Market participants would closely track inflation prints for signs of moderation in momentum. All eyes are likely to be on the AEs, as they struggle to temper inflation in coming months. With US economy not showing any signs of moderation, the US FED may be pushed to hike another 75bps in Sept 22 FOMC meet. Yields are likely to move in either direction driven by incoming data. Any negative data on growth would likely drive yields down whilst any indication of sustaining momentum in inflation could take yields higher.
10Y yield is likely to be in range of 7.20%-7.50% in the near term. Investors are advised to continue with their asset-allocation based investment in debt funds, based on respective investment horizons and risk appetite.
Source: RBI, MOSPI, CMIE, FIMMDA, NSDL, Bloomberg, ICRA Analytics Ltd.