Bond yields may harden by Q4 as various fiscal risks persist

The yield on the 10-year government security (G-sec; 7.17 GS2028) hardened considerably in Q2 FY2019 and peaked at 8.18% on September 11, before cooling off to around 7.7-7.8% in mid-November 2018. It is expected to trade in a wide range of 7.6-8% in the remainder of Q3 FY2019, driven by domestic and global factors.

Crude oil prices have charted a volatile path in recent months, which has rapidly transmitted into both bond yields and the US$-INR cross rate, given their impact on inflation and the twin deficits. The price of the Indian crude oil basket rose to US$85.2/barrel on October 4. However, it has eased sharply to US$65.6/barrel on November 15, driven by the announcement of exemptions from US sanctions on Iran for eight jurisdictions, including India, and some concerns on over-supply. Moreover, after displaying a substantial depreciation from April 2018 to mid-October 2018, the rupee has appreciated around 2% relative to the dollar in subsequent sessions.

The price of the Indian crude oil basket appears likely to remain considerably lower in the immediate term, than the average of US$80/barrel in October 2018. Nevertheless, supply-demand balances, geopolitical developments, and concerns regarding the impact of trade wars on global growth would continue to impart volatility to crude prices and the outlook for bond yields.

Following the correction in the CPI inflation to 3.3% in October 2018, and the pullback in crude oil prices and the rupee, concerns regarding the trajectory of inflation have receded considerably. Accordingly, the Monetary Policy Committee is likely to leave the repo rate unchanged in the December 2018 policy review, despite having revised the monetary policy stance to calibrated tightening in October 2018, which would contribute to keep G-sec yields steady.

On a daily average basis, systematic liquidity shifted from surplus in the first quarter of this fiscal to deficit in Q2. To infuse durable liquidity, the Reserve Bank of India (RBI) conducted open market operations (OMOs) to purchase G-sec of Rs 86,000 crore in April-October FY2019, and has announced additional OMO purchases of Rs 40,000 crore in November, which has helped to cool G-sec yields.

Systemic liquidity conditions are expected to remain tight in this quarter, on account of the harvest, marriage season, legislative elections, upcoming advance tax payment and busy season for bank credit. Therefore, we expect a continuation of OMOs to purchase G-sec by the RBI, with three weekly auctions of Rs 10,000 crore each during December 2018, which would dampen G-sec yields.

The size of the planned G-sec issuance for FY2019 has been pared from the budgeted level, and officials have reiterated that a fiscal slippage in FY2019 would be avoided. However, various fiscal risks persist, which the markets would continue to monitor. A build-up of expectations about an upward revision in the G-sec issuance for Q4 FY2019, may push up yields towards the end of the quarter.

The US Federal Reserve appears set for one more rate hike in December 2018. If the threat of trade wars de-escalates, and once the US markets start to price in two to three rate hikes for 2019, the US 10-year yield may rise above 3.3%, which may push up the G-sec yields as well.

Overall, we expect G-sec yields to continue to display two-way volatility and range between 7.6-8% in the remainder of Q3 FY2019.

The writer is principal economist, Icra