Market not yet confident on Budget, MPC meet

It was yet another week for the equities as a leader among asset classes as major stock indices advanced strongly, fuelled by solid global growth and robust consumer and business confidence.

To put it in perspective, the S&P 500 index has rallied 3.5% since the beginning of the year, the best start to a year since 1987. The poor cousin, bonds and treasuries had their weak moments yet again as the yield on the US 10-year note rose 11 basis points to 2.57% in response to growing anticipation that major central banks may follow the US Federal Reserve and shift to a less accommodative monetary policies in 2018. Alongside, the strong macro backdrop, along with concerns over the tenuous state of the Iran nuclear agreement, helped lift crude prices to recent highs and market volatility, (VIX), rose to 10 from 9.25 a week ago.

As results’ season kicks off and we get to see how major companies performed across geographies through their quarterly results, talks of the pace of rate hikes in both major and emerging economies dominated discussion themes. The US reported its strongest monthly retail sales data since 2014. Also, its small business confidence hit a record in 2017.

Tax cuts and regulatory reform were cited as catalysts. North and South Korea resumed talks for the first time in two years and both warring neighbours may participate in the Winter Olympics at Pyeongchang. In currency markets, the European single currency tested the 1.22 handle as the European Central Bank's (ECB) new found passion for tightening is seen propelling the currency higher.

This, however, complicates the ECB’s job of trying to lift eurozone towards a 2% inflation goal. A stronger currency will keep import prices subdued and is often a headwind for the exporters, potentially constraining economic growth.

Indian bond markets may still have to wait to get a respite from sellers’ onslaught it appears as the market got yet another jolt after market hours on Friday. Annual retail inflation accelerated in December to a 17-month high of 5.21%, mainly driven by faster rises in prices of food and fuel products. While a higher headline number has been largely factored in and seasonality also considered in future trajectory, the market may be on an edge. One would invariably start wondering how would the Budget address the twin deficits and how would the supply factor respond to the diminishing appetite for bonds and also a regulatory tapering of key statutory ratio that has hitherto led to demand for government securities.

Alongside the CPI data, industrial output data (IIP) came a cropper as it underlined the strong growth momentum that is believed to have been kicking in. The data released on Friday showed that the index, after slowing for two straight months, bounced back in November, rising 8.4%, signalling a revival. These may possibly be the last key set of data points before the Federal Budget on the 1st of February

For bond traders, something that stands out as a likely mispricing is the spread at the short end of the rate curve, The spread between a 4-5 year bond over repo rate is at a five-year high and far above the average spread of around 60 basis points. This begs the assumption that we should be witnessing sharp rate hikes over the next two years. Given the broadly weaker growth background, it is difficult to understand how this aberration sustains so long.

While bond traders prepare for the February monetary policy meeting and the Budget, the buoyant stock market confidence is yet to be seen on the bond street. The 10-year benchmark (the new 7.17% 2028 security) is rich at current levels around 7.25%. Within at 7.10-7.30% range, the preference is for an undershoot, sometime soon.

KEEPING AN EYE

• The 10-year benchmark (the new 7.17% 2028 security) is rich at current levels around 7.25%
   
• Within at 7.10-7.30% range, the preference is for an undershoot, sometime soon

The writer is a market expert