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Elevated crude oil prices and the ‘higher for longer’ narrative for US interest rates continue to dominate the investor sentiment in the bond market. Escalating tensions in the Middle East have added to the prevailing nervousness. It is keeping market participants on their toes. So much so that it took away focus from some remarkable improvements in the domestic macros and market dynamics.

Before going into the discussion of domestic trends that we are seeing, let’s first explore the issue related to the recent flareup of geo-political conflict between Israel and Palestine and its impact on the bond markets.

West Asian Conflict-Lessons from history

Our understanding of geopolitics is no better than anybody else following news regularly. However, based on the lessons from past conflicts in the region and borrowed wisdom of geo-political experts, we note following

* Conflict in Middle East can have a significant impact on the global and Indian economy through two major channels – (1) crude oil supply/prices, and (2) disruption of global trade route.

* Neither Israel nor Palestine are significant producers of crude oil. Thus, a localized war between the two might not have any material impact on the global oil supply – keeping prices under check. 

* Direct involvement of major oil producing nations particularly Iran can push oil prices higher, though experts assign a low probability to this outcome.

* Middle East has three key chokepoints in the global trade route - the Suez Canal, and the straits of Hormuz and Bab-el-Mandeb. Wider spread of war could pose a threat to global trade routes which in turn would be inflationary.

Table – I: Conflict Scenarios and Potential Market Impact

In conclusion, potential market impact of the current middle eastern conflict can be categorized as – ‘high impact - low probability’ outcome.

Till now, Indian bond yields have shown resilience with the 10-year IGB (Indian government bond) trading almost at the same level as prevailed before the war broke out. While crude oil prices jumped about 10% in anticipation of broader conflict hurting the global oil supply.

Table – II: Indian Bond yields sowing resilience to geopolitical tensions and rising crude oil 

We expect the resiliency of the Indian bonds and the rupee to continue supported by strong domestic fundamentals unless crude oil moves up substantially from current levels.    

Fiscal Flexibility

Government’s tax collections have shown a healthy growth in the first half of the fiscal year 2023-24. As per the government’s press release, direct tax collections for FY24 up to October 9, 2023 have grown by 21.8% compared to same period last year. This is significantly higher than the government’s budgeted direct tax growth target of 10.5% YoY.

Chart – I: Tax Revenues continue to grow at a faster pace than budget estimates

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