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Many more legs left in this bond market rally

Avnish Jain, Head - Fixed Income, Canara Robeco MF

25th November 2016

In a nutshell

Avnish says that while bond markets have priced in a 25-50 bps rate cut in the near to medium term as an immediate fall out of demonetization, there are many more legs left in this bond market rally over the next couple of years. The longer term rub-off from demonetization will include lower inflation, lower supply of government paper and healthier fiscal situation on the back of higher tax collections - all of which augur well for lower yields over the next couple of years. While "Trumpflation" is impacting our currency and equity markets, debt markets are well cushioned due to the renewed positive outlook on interest rates post demonetization.

WF: Demonetization is turning out to be a black swan event for our debt market, albeit with favourable consequences. How do you see the medium and long term prospects for short and long term yields, on the back of this huge liquidity infusion?

Avnish: The upfront liquidity infusion in the banking system is likely to be hugely positive for the bond markets, both in short term as well as long term. In the short term, excess liquidity is going to pull down the short end of the curve. The huge influx of liquidity is going to propel banks to park the liquidity in SLR securities (Central/State government bonds) as well as AAA corporate paper, thereby bringing down yields across the curve as demand exceeds supply.

In the longer term, demonetization will again have a positive rub-off. The sudden short term contraction in demand, is likely to bring down core inflation and the overall inflation in the near term. Going forward, reduction in cash transactions is likely to increase liquidity in the financial system, thereby bringing down bank deposit rates and hence lending rates.

More than expected drop in inflation is likely to nudge RBI to cut rates to support growth, more than earlier envisaged (if demonetization had not happened). This is likely to take rates lower in the next 1-2 years.

Demonetization is also incrementally positive from a fiscal point of view. Tax revenue to the government is expected to increase and some amount of the currency in circulation which is not expected to come back may be fiscally accretive depending upon how it is accounted for. This in turn is expected to reduce supply of government bonds in the coming financial years.

WF: Are the positives already priced into bond yields or are we at the cusp of a new bull market in bonds?

Avnish: The market has already started discounting 25-50 bps rate cut in next few policies. However, the situation is evolving, and steps need to be taken by the government to ensure that the demonetized notes do not simply get replaced by new notes. More concrete steps to attack the "black economy" is likely to lead to better financial market liquidity and lower rates over the medium to long term. We believe that there are more legs left in the rally.

WF: Ambit Capital forecasts a 360 bps cut in banks' base rates over the next 3-4 years, consequent to demonetization (click here). That would imply a strong bonds bull market over the next 3-4 years. Would you share this assessment?

Avnish: We believe that this assessment may not be realistic considering the banks are still struggling from stressed assets and the recent demonetization may create more pain in the short term. However, the excess liquidity in the system has forced banks to cut deposit rates and consequently over the next year or so we are likely to see continued downtrend in lending rates, albeit at a faster pace than in the recent past.

RBI policy rates are likely to see a downtrend depending on evolving government policy and global events

WF: While we rejoice bullish times for Indian bond markets, global bond markets are witnessing a huge "Trumpflation" sell off. Are we likely to see the much feared and much anticipated bursting of the global bond bubble now? What implications might this have on our bond and equity markets and our currency?

Avnish: With slow growth and weak inflation still persisting in the world (maybe with exception of US), higher rates are going to stall any economic growth, putting a cap on how high rates can go up. Further the markets have started discounting higher rates based on assumptions on policies that may be formed by the new administration under Donald Trump. We have to wait and see the final shape of policy making in early part of 2017, which may be a diluted version of the election rhetoric

In the short term emerging markets may continue to fear the brunt of risk-off sparked by Trump election and no clear picture may emerge till Donald Trump is sworn in by January 2017.

Indian equity markets may continue to see impact due to twin effects of global risk-off and demonetization. Debt markets are likely to continue to do well on back of huge influx of liquidity, expected drop in inflation and positive effects on the fiscal front due to demonetization. Slowdown in growth in the short term is likely to further put downward pressure on inflation, thereby giving more room for RBI to reduce rates

INR may be less impacted vis-a-vis EM currencies due to de-monetization, as imports may shrink in the short term due to contraction in demand.

WF: How are you aligning your fixed income funds to evolving market conditions? What are some of the key changes you have made in the past few weeks?

Avnish: Our duration funds were already running higher duration on expectation of lower inflation and further policy cuts in near term. Post demonetization we continue to run our positions while reducing any cash positions in the funds. There has been no major change in portfolio positioning

WF: Where do you see the best opportunities now in our fixed income market?

Avnish: There is good opportunity in AAA Corporate Bonds and State Development Loans (SDL), where the spreads are attractive. The rally in government bonds has not been fully transmitted in the corporate bond/SDL segments. As liquidity overhang persists in the system, banks may look to increase exposure to top rated corporate papers, which are providing attractive yields vis-à-vis gilts. Accordingly, funds like Dynamic Bond fund, Income fund and Gilt funds are expected to do well on account of lower trending interest rates over the next 1-2 years due to

  1. Continuing low inflation on WPI reflected by low credit off-take / capex for the medium term

  2. Indian demonetization providing a significant structural change in the CPI inflation outlook due to deep impact on consumer demand

  3. Continuing global slowdown, outlook on commodities, India's relative currency outlook & govt's reforms stance as some of the key factors likely to attract FII money to Indian Sovereign / High Quality corporate bonds.

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