Fresh buying by banks may come at higher yields

On Wednesday, the US Federal Reserve raised federal funds rate by 25 basis points (bps), to adopt a new range of 0.50%-0.75% with hawkish statements that suggest the calendar year (CY) 2017 can see as many as three hikes, as the dots suggest increasing probabilities of further tightening going forward. One would not be mistaken to call this a December-2015 redux, as the Federal Reserve Bank had indicated a likely three-step increase in 2016, at the same time last year. But, it managed a solitary hike. Ofcourse, the broader economic conditions are far too different this time and the party might be over on cheap interest rates, especially mortgages.

The aftermath of this week’s Federal Open Market Committee action and the press conference by the Fed chairperson suggest things have changed for the good and US economy is recovering, with inflation and unemployment levels on track. Bond markets sold off across the globe, with emerging markets (EMs) mostly bearing the brunt. The US Dollar Index, a broader measure of dollar’s strength against a basket of major currencies, registered an eight-year high. Stock markets have broadly been flat as a US rate hike connotes differently to different economic regimes. The US 10-year bond yield tested 2.65% in the sessions following the hike and both European and Asian markets felt the heat of this bond sell-off. China had to cry halt to its futures trading markets on Thursday. However, mainstream economists believe markets do not always follow the US money market rates as other market factors come into play. For example, between 2004 and 2006, when the Fed raised its benchmark short-term rate, yields on the 10-year US Treasury notes remained flat due to a strong global appetite for US bonds.

Indian markets reacted more negatively than expected. A rate hike in the US was a given and an RBI pause amid weak economic data and lower than expected inflation (CPI reading showed 3.63% against expectations of 3.90%) suggested higher chances of a cut in the February Monetary Policy Committee meeting. However, benchmark bond yields spiked 43 bps (from 6.11% to 6.54%) and long tenor bonds have sold off more, suggesting a steepening and an attempt to reduce duration. Foreign investors have sold heavily with sporadic buying activity from local investors. Sentiment should remain subdued as year-end factor could see low volumes and higher volatility.

On the data front, November data showed a widening trade deficit to $13 billion, year-over-year. Surge in gold and crude imports was the main factor. The rupee weakened nearly 0.5% post US-rate news. However, with the stock market relatively stable and dollar correcting towards the end of week, the local currency recovered some of its losses.

In the week ahead amid liquidity glut, Indian bonds will still track the US yields for fresh short-term direction. Data on demonetization and speculation on budget sops will be key drivers for the domestic players. With the major event of FOMC decision out of the way and the markets adjusting to the event,  now, the focus will shift to the domestic fundamental factors and what the RBI stance would be. It is expected that the RBI would continue with the accommodative stance to support growth. The markets would start factoring these and at the higher yield levels there would be fresh buying from the insurance and banks. Benchmark yields may trade in a range of 6.40% to 6.50%.

FOCUS ON RBI

• Benchmark bond yields spiked 43 bps and long tenor bonds have sold off more, suggesting a steepening and an attempt to reduce duration
   
• Foreign investors have sold heavily with sporadic buying activity from local investors
   
• However, Indian bonds will still track the US yields for fresh short-term direction. Data on demonetization and speculation on budget sops will be key drivers for the domestic players. Focus to shift to the RBI stance

The writer is executive director, Lakshmi Vilas Bank