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This quote by Howard Marks, aptly portrays the changes in market narratives over the last few months. In the US, the bond market narrative has been toggling between two extremes - “persistent high inflation” and “recession”.

This has put the bond markets around the world on an emotional roller coaster. A month back, the US treasury futures were pricing for two or more rate cuts. Now, the expectation has shifted to two more rate hikes in 2023.

This has not just pushed US treasury yields higher; but moved the sentiments in the Indian bond market too; sometimes in contrast to the local developments.  The 10-year Indian government bond (Gsec) yield which had fallen to lows of 6.96% during early June, has jumped to the peak of 7.17% before falling back to the current levels of 7.07%.

Chart – I: Indian bond yields has been tracking long term US treasury yields

The US Fed is expected to hike the Fed Funds rate by 25 basis points in its upcoming review meeting on July 26^th. This is already a part of market psyche. Thus, the rate hike by itself is unlikely to have any material impact on the markets. Instead, the bond market will closely follow the Fed’s language to find cues about the future course of monetary policy.

We foresee following possible outcomes:

The broader picture is that the rate hiking cycle is near its end. One or two tactical rate hikes by the US Fed cannot be ruled out. But these are unlikely to have any lasting impact on the Indian bond markets.

At this juncture, we shall be focusing more on the domestic developments particularly around the inflation and liquidity.

Shifting Liquidity Dynamics

The less talked aspect of the RBI’s monetary policy normalization last year, was its covert tightening of liquidity condition. It reduced the durable liquidity surplus from ~Rs. 11 trillion in December 2021 to below ~Rs. 3 trillion by December 2022, and tightened further to below Rs. 1 trillion by April 2023.    

Back in April, we expected the core liquidity (Banks’ excess liquidity with the RBI+ government balance) to turn into deficit from May 2023. 

But it turned out differently in the last three months. The core liquidity increased to surplus of over Rs. 3.7 trillion as per the latest available data for July 14, 2023. This was mainly contributed by – (1) deposit of Rs. 2000 currency notes after the RBI’s announcement to withdraw it from circulation, and (2) Foreign Exchange (FX) purchases by the RBI.    

Since the announcement of Rs. 2000 currency note withdrawal on May 19, 2023, the currency in circulation (CIC) has declined by Rs. 1.26 trillion (as per the latest available data on July 14, 2023). Typically, this used to be a calm period for the CIC with no major changes. Thus, almost entire drop in CIC (increase in banking system liquidity) can be attributed to the deposit of Rs. 2000 currency notes.    

On the FX front, the RBI has been quite aggressive in rebuilding it reserves. It bought over USD 15 billion of foreign exchange during April and May 2023. The FX buying spree continued in June and in July so far. Our reverse calculation from changes in liquidity condition during June and July, indicates additional USD 6 billion FX purchases by the RBI. These FX purchases added around Rs. 1.7 trillion of durable liquidity into the banking system.  

Chart – II: Liquidity condition eased due to Rs. 2000 note withdrawal & RBI’s FX buying

The broader view of dollar depreciation going forward and foreign investors rising interest in Indian financial markets, support continuation of FPI inflows into the India equity and debt markets. This would ease the liquidity condition even further.

From the bond markets’ perspective, the impact of liquidity is two-fold:

1. Easy liquidity condition brought down the short-term yields in the money markets. The yield on the 1-year treasury bill came down from 7.16% on March 31, 2023, to around 6.87% on July 20, 2023. During the same period, AAA PSU CDs witnessed around 23 bps drop in yields from 7.61% to 7.38%.

Given our view on liquidity, we expect money market rates to remain well anchored around the policy repo rate. This, in turn, might keep the front end of the yield curve steep.

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