Bond markets are waiting for the Union Budget 2017-18 to be presented to parliament on the 1st of February 2017 for direction on bond yields. The benchmark ten year government bond, the 6.97% 2026 bond has traded in a range of 6.35% to 6.55% since RBI policy in the first week of December 2016. The bond is currently trading at yields of 6.41%.
The government’s fiscal deficit target for 2017-18 is 3% of GDP as per the FRMB (Fiscal Responsibility and Budget Management) roadmap. Fiscal deficit for this fiscal year 2016-17 would be at 3.5% of GDP or even lower going by the higher than estimated nominal GDP at 11.9% as per the advance estimates of the CSO (Central Statistical Office).
Given that the real GDP growth for fiscal 2016-17 has been revised from 7.6% to 7.1% on demonetization, there is an expectation that the government will look to spend heavily in the coming fiscal year to pull up GDP growth. Government spending, if not done out of gains from undisclosed income on demonetization, can result in FRBM target of 3% of GDP for fiscal year 2017-18 being set aside and the government could maintain fiscal deficit at 3.5% of GDP, which would push up government borrowing for next year.
The markets can easily absorb higher government borrowing if the rise in reasonable and bond market sentiments would be positive. Assuming a nominal GDP growth of 12% for fiscal 2017-18, fiscal deficit would be around Rs 5.9 trillion and net government borrowing would be around Rs 4.9 trillion to Rs 5 trillion (82% of gross fiscal deficit), a rise of 14% from fiscal 2016-17 levels. Fiscal expansion leads to rise in bank deposits, higher inflows into pension funds, higher investments in insurance and mutual funds, higher foreign capital inflows and currency stability that would lead to healthy demand for government bonds.
Government borrowing exceeding Rs 5 trillion (net) could pose problems for the market to absorb the borrowing and bond market sentiments could get hurt. Banks that are sitting on excess SLR of around 7.5% (28% as against SLR limit of 20.5%) may shun government bonds on worries of higher yields and this could prevent other market participants to turn cautious on yields and postpone bond purchases, which in turn could make yields rise faster than expected.
The former scenario of net government borrowing at around Rs 4.9 to Rs 5 trillion looks more probable with a good chance that the government can even stick to fiscal deficit target of 3% of GDP, which would then be highly positive for markets in the short term.
The ten year benchmark bond, the 6.97% 2026 bond saw yields rise by 2bps week on week to close at levels of 6.41%. The old ten year benchmark bond, the 7.59% 2026 bond saw yields rise by 2bps to close at 6.55% levels while the 7.88% 2030 bond and the 8.13% 2045 bond saw yields rise by 1bps and 6bps respectively to close at levels of 6.87% and 7.12%. Bond yields will stay ranged as markets await the budget.
OIS market saw one year OIS yields close up by 1bps and five year OIS yields close up by 2bps week on week. One year OIS yield closed at 6.18% while five year OIS yield closed at 6.25%. OIS yield curve will steepen as markets factor in faster pace of Fed rate hikes.
Credit spreads closed down last week. Three-year benchmark AAA corporate bond yields closed flat week on week at 6.83% levels. Credit spreads fell by 4 bps to close at 37bps levels. Five-year benchmark AAA bond yields fell by 2bps to close at 7.10% with spreads down by 3bps at 55bps levels. Ten-year benchmark AAA bond yields fell by 3bps to close at 7.24% levels with spreads down by 6bps at 72bps. Credit spreads are likely to stay ranged until the budget.
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 Facilities (MSF or Marginal Standing Facility and Export Credit Refinance) and MSS bond issuance was in surplus of Rs 7576 billion as of 13th January 2017. The surplus was Rs 7479 billion in the week previous to last. MSS bonds outstanding were Rs 5966 billion. Liquidity will stay easy as demonetization inflows stay in the system.