Indian Bonds and equities see extreme selling by foreign portfolio investors

Indian Bonds and equities see extreme selling by foreign portfolio investors. Where are we headed next?

The Indian Sovereign Yield curve was the steepest in many years when the spread of the 10y bond yield over the call rate had widened to 178bps (when the 10y yield hit 7.78% for the first time recently). This is not unusual though as we have witnessed similar steepening on previous occasions when markets have realized that the rate cut cycle is over and the central bank would embark on a tightening spree. There were two main factors for the central bank to turn hawkish:

1. Sticky Core inflation: Inflation excluding fuel and food prices has been steady at 5% and the central bank would have wanted to preempt prices from spiraling higher.

2. Monetary Policy tightening by the Federal Reserve: The US Federal Reserve had announced trimming of its balance sheet size and had commenced gradual normalization of policy rates. This would have narrowed the rate differential between India and the US, thereby resulting in flight of rate sensitive capital.

There were other factors too that had contributed to the spike in yields. First being the lack of participation of public sector banks in the bond market. Public sector banks are one of the major buyers of government debt and they have almost an insatiable appetite for government bonds, firstly in order to meet their SLR requirements and secondly in order to deploy surplus funds in case of lack of lending opportunities amidst slow credit off take. However, statements by deputy governor Viral Acharya that banks should manage their own interest rate risk had turned banks averse to holding duration especially when rates seemed heading northward.

There were also concerns over the central government not meeting its budgeted indirect tax collection, resulting in fiscal slippage. This too had contributed to the spike in yields.

In order to address the above factors and to cool off yields, (to reduce government borrowing cost) the RBI and the government announced a slew of demand side and supply side measures respectively.

The supply side measures announced by the government were:

1. Reduction in borrowing for FY19 by Rs 50000 Cr

2. Reducing the borrowing in the first half of the fiscal to 48% of total borrowing instead of the usual 65%

3. Spreading out issuances across the yield curve i.e. issuing more in the front end

Measures announced by the RBI to address the demand side were:

1. Allowing banks to spread out their MTM losses (resulting from spike in yields over four quarters)

2. Relaxing the provisioning norms (temporarily) for non-performing loans

3. Lowering its inflation forecast in the April monetary policy (dovish monetary policy)

4. Increasing FPI limit in government securities to 5.5% of outstanding stock from earlier 5%

As a result of the above measures, the 10y yields cooled off from 7.70% to 7.12%. However the public sector banks used this rally as an opportunity to minimize their losses and exit their positions, rather than building up fresh positions. Most of the above measures failed to convince the markets that a rate hike later this year was off the table. The minutes of the April MPC meet were much more hawkish than what the policy statement seemed to suggest and that further exacerbated the sentiment in the bond market. Rs 400Cr of 2020 bond were devolved on primary dealers in the most recent auction, which points to a lack of demand. Rising crude prices and resulting inflation pass through now seem imminent. Hike in MSPs, heading into general elections next year is likely to contribute another 0.5% to headline inflation going forward.

With the US front end rates heading higher, there is a risk of capital flight from the Emerging markets. Inflation expectations are picking up in the US (as indicated by firming breakevens) and this would further dampen the sentiment for EM assets. Monetary policy communication flip-flops by the RBI have spooked FPIs. Volatility in the Rupee has not helped either. FPIs have sold heavily in the domestic bond markets this week. FPIs have so far pulled out net USD 1.6Bn from equities and USD 1.4Bn from bond markets in April so far. Higher Bond yields due to unwinding and uncertainty on oil prices does not bode well for the rupee which is already on a weakening spree towards 68 levels.