Gujarat Poll results, strong trade data, record levels of Sensex & Nifty and Fed on a steady rate hike path point to a surge in capital flows in 2018. RBI will have a tough time in managing the liquidity arising from capital flows as it purchases USD to prevent a sharp INR appreciation. Sterilization of fx liquidity will result in more bond supply through OMO and MSS auctions. High liquidity will also increase RBI’s wariness on rising inflation expectations. Bond markets will be circumspect on the cause & effect of surging capital flows. However credit spreads will benefit from liquidity as markets take on higher risk.
Gujarat Assembly polls that got over last week will see the ruling BJP stay in power as per exit polls. The counting is on Monday the 18th of December and if results go according to predictions, markets will take on more risk as the probability of the Modi government regaining power in the national elections in 2019 will increase.
Markets will expect the government to continue with reforms and thrust on economic growth and with Moody’s raising India’s rating on the back of reforms, the government will stay on course.
Trade data for November 2017 showed a sharp jump of 30.55% indicating both a revival in global trade and improved global economic conditions. Higher export growth, if sustained, raises prospects of a faster growth in GDP as output increases.
Sensex & Nifty are trading at record highs amidst expectations of growth revival, improved corporate earnings and strong domestic and global flows into equities. Mutual funds are seeing record flows into equities month on month while FII’s have been strong buyers of equities and debt in this fiscal year. Click here for FII flows into equities and debt. Growth prospects and an appreciating INR will drive further flows into equities and debt.
Fed in its policy meet last week raised rates and guided for more rate hikes in 2018 but the pace of hikes will be gradual as its committee members stay cautious on lack of inflation expectations. Asset markets will be enthused by the Fed’s tone on inflation and will drive asset prices higher, which is positive for global capital flows.
The 10 year benchmark government bond, the 6.79% 2027 bond, saw yields rise by 6bps week on week to close at levels of 7.14%. The on the run bond, the 6.79% 2029 bond saw yields close 3bp up at 7.15% levels and the 6.68% 2031 bond saw yields close up by 7bps at 7.21%. The long bond, the 7.06% 2046 bond saw yields close up by 6bps at levels of 7.47%. Gsec yields would stay at higher levels on expectations of surging system liquidity.
The OIS market saw 5 year OIS yields closing 8bps higher week on week at levels of 6.64%. The one year OIS yield closed up by 8bps at 6.37%. OIS yield curve will steepen on the back of Fed rate hikes and bond market worries.
Corporate bonds saw 5 year AAA corporate bond yields close up by 6bps at levels of 7.58% and 10 year AAA corporate bond yields close up by 10bps at 7.85%. 5 year AAA spreads rose by 4bps at 52bps and 10 year AAA spreads rose by 4bps at 59bps. Corporate bond yields will be sticky on the back of high system liquidity and spreads will move on movements in government bond yields.
System liquidity as measured by bids for Repo, Reverse Repo, Term Repo and Term Reverse Repo in the LAF (Liquidity Adjustment Facility) auctions of the RBI and drawdown from Standing Facility (MSF or Marginal Standing Facility) and MSS/CMB bond issuance was in surplus of Rs 1406 billion as of 15th December 2017. The surplus was Rs 2219 billion as of 8th December. Liquidity will stay comfortable on government spending, bond repurchases and RBI fx purchases though advance tax payouts in December will lower the liquidity in the short term.