Volatility to persist in the bond mart

Indian markets continue to be roiled by the two unexpected events – Trump's triumph in the US elections and demonetisation drive announced by the Indian government. While the former event leads to a plethora of questions as to how the global economy will react to the measures and policies of the new government in the US, the latter event is already seen as leading to short term corrections in growth trajectory while entailing long term benefits for Indian economy. In a humungous cash economy like ours where the cash component is a very high percentage of the GDP as opposed to half of it in most major economies, much will depend on how quickly the currency pool is replenished and day to day life of common man moves smoothly.

Banks continue to absorb abnormally large amounts of cash from the public arising out of the demonetisation drive and this is a new normal. Of an estimated 15 lakh crore of cash-to-come, almost 40% has already found its way into banks as deposits. An immediate impact is the unprecedentedly vast amounts of absorption by RBI under the reverse repo window over various tenors. As at last estimate, about Rs 3.40 lakh crore has been placed under the reverse repo window by banks. The moot point is if RBI will have sufficient securities to absorb further incremental liquidity, will cash management bills be the next tool, and if this will lead to some emergency measures that aim to give rise the liquidity glut.

The larger issue however is a weakening rupee, which has already depreciated by nearly 2.50% in a fortnight's time. Although a rate cut is the logical expectation as a response to the liquidity surfeit and collapse of the shorter end of the money market curve, rupee's weakness may weigh against such a move in the immediate future.

On the data front, consumer price inflation (CPI) and wholesale price index (WPI) continued to show softer reading and below estimates, thereby providing comfort to RBI. Arrival of kharif crop against the backdrop of a good monsoon will likely exert downside pressure on the prices and may well offset the temporary disruption due to cash shortage arising out of rationed cash disbursements.

Bonds continued to rally as excess liquidity found bonds the best asset class to invest. With credit growth yet to take-off any meaningfully and equity markets hostage to global factors and therefore volatile and weaker, fixed income markets attracted more buyers. Benchmark 10-year yield has dropped by more than 40 basis points in the last 2 weeks, spreads between corporate and sovereign bonds have compressed 2-5 basis and the auction on Friday drew good bid to cover ratio. Although there was a devolvement in a long tenor bond, markets are likely to perceive this as a bullish sign.

Overall, a highly priced-in December rate hike by the Federal Reserve and a liquidity awashed domestic market will be the two major factors for some more time to come. Participants will also keenly follow the developments on the demonetisation issue for further clues. The bond markets are expected to continue with high degree of volatility. The shorter end of the curve including the money market instruments and T-Bills will be favoured instruments of the market till the banks get a hang of the way the extra liquidity due to the cash deposits is going to pan out.

The writer is executive director Lakshmi Vilas Bank