Repo cut later, bond yields headed down

Friday’s 25 basis point (bps) reduction in the repo rate is likely to spur a bond market rally going forward.

Bond markets will start expecting at least one more repo rate cut in the next couple of months and start taking bond yields down.

The ten-year benchmark bond is trading at levels of 7.75% and yields will trend down towards 7.50% in coming months.

Falling government bond yields will lead to corporate bond yields coming off, too. 

The reason the bond markets will build in one more rate cut from here is the Reserve Bank of India’s (RBI’s) policy stance, which primarily addresses “accentuated risks to growth”.

Incoming economic data have not been very positive with the April manufacturing growth coming in at a 17-month low. Four-wheeler and two-wheeler sales, too, have shown negative growth across manufacturers.

On the global front, central banks from the European Central Bank that cut key rates by 25 bps on Thursday to the Bank of Japan are worried on lack of growth in their economies.

The US Federal Reserve has reaffirmed its monthly bond purchases of $85 billion on the back of worries about sluggish growth.

RBI’s own forecast of gross domestic product (GDP) growth at 5.7% is lower than the government’s forecast of 6.4%. The central bank does not see much scope for growth this year and given its commitment to growth, it is likely to cut the repo rate in its forthcoming policy review.

On the inflation front, RBI’s forecast at 5.5% for this fiscal is well below the average of 7.3% seen last fiscal. Weak global commodity prices with oil prices down over 10% over the last few months will help bring down inflation expectations.

Liquidity conditions are more positive than they appear now. Banks are borrowing around Rs 80,000 crore from the RBI on a daily basis, but this is largely due to high cash balances of the government. Government spending will improve system liquidity going forward. 

Investors should position their fixed-income portfolios for a further fall in bond yields.

Investors who do not invest directly in the bond markets should look at long-term gilt and income funds and short-term income funds as these funds are the best positioned to capture the fall in bond yields. Dynamically managed bond funds that are running positive views on yields will also benefit from falling bond yields.

The risks to a positive view on bond yields are external shocks, rising commodity prices and political instability. In the current environment of falling growth expectations and stable inflation expectations, a positive bond yield view is a risk worth taking.

Parthasarathy is the editor of  www.investorsareidiots.com, a website for investors.