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Recent Bond Market Volatility And Portfolio Strategies

After attempting to find its footing post the June RBI policy, bond market equilibrium has lately been disturbed anew. The first trigger for this was the August RBI policy where the RBI/MPC seemingly further lifted the bar for the next rate cut. The market price action over the next few days was perhaps a little exaggerated, with participants struggling to find at what next level ‘genuine’ investor interest comes in. The rise in yields was broken by the surprise sovereign upgrade from S&P, only to be neutralized the very next trading day by fiscal fears on account of proposed GST rate rationalization. It is to be noted that the global rate backdrop over this period has been largely neutral: one doesn’t look anxiously anymore first thing in the morning where US 10 year yields are (though that anxiety is always there at the back of the mind).

There are 4 aspects to our assessment framework for the market currently. We delve deeper into them below:

1. The global and local macro-economic backdrop

* In our view this remains decidedly bullish for bonds. The US economy is finally slowing. The clearest way to see this is to strip out government spending and the volatile trade component (the latter in light of tariff deadlines) and focus on domestic consumption plus investments, commonly referred to as private domestic final purchases. The Fed Chair has alluded to this in the past as well. This metric has slowed very substantially this year. The labor market slowdown in the US is also now well documented especially in the light of recent non-farm payroll downward revisions as well as a weaker picture being painted by the quarterly census on employment.

* The Fed is in a tight spot currently: it broadly acknowledges that policy is a shade restrictive but is relying on backward looking data to decide when to ease, when it knows that monetary policy acts with ‘long and variable lags’. This discomfort of positioning is getting seen in more divergence within the FOMC. It also raises the probability that when the Fed starts responding to weakening data, it may have to take bigger cuts to ‘catch-up’.

* The trend of broad dollar depreciation may therefore continue given the backdrop of slowing growth and likely more Fed rate cuts. This should keep pushing flows into other bond markets including, as seen recently, into India.

* Meanwhile, China’s growth rate may also slow over second half as the lift from trade ahead of tariff implementation fades. Thus, overall world growth has likely already hit a soft patch that may take a few quarters to turn.

* A similar prognosis can be made for our domestic economy as well, with the soft patch here attributable to global uncertainties (recently escalated with the US tariff announcements) as well as a slowdown in the consumer leverage cycle.

2. Recent Fiscal Fears

* There has been some concern brewing with respect to tax collections, where year to date growth is negative. The very high RBI dividend has somewhat cushioned the impact thus far, but tax collections need to meaningfully pick up in the months ahead. While this is definitely a point to be monitored, it is as yet too early to worry about any meaningful fiscal slippage on this account. There is precedence for a weak start to tax collection picking steam later in the year. Also, to be noted, the nominal GDP growth assumed in the budget is now only 8% versus the final numbers for FY25.

* The proposed GST rate rationalization broadly equates to 50 bps total annual fiscal impact borne 1/3^rd and 2/3^rd by center and states respectively. However, impact for FY26 will be half that since implementation will be for half year only. Also we don’t know yet to what extent states may ask for offsets via hike on other taxable items in order to minimize impact as well. Further, there is a compensation cess pool available for net-offs. Finally, other measures to neutralize some of the tax loss impact may very well be undertaken (Eg: excise hike on fuel products without changing retail prices, given the sharp fall in oil prices seen recently).

* There’s an upcoming pay commission to contend with as well. However, as per media reports there could be some delay here (Click here). Also, we expect most of the pay commission outgo to constitute expenditure switching for the government, rather than outright fiscal expansion.

* A point that needs reiteration: we have now seen a responsible fiscal stance from the government over an extended period of time, including over the pandemic shock. Thus, we don’t expect a sudden change to aggressive expansion that will either jeopardize the debt/GDP framework indicated or levy a very high burden of supply to the bond market.

3. RBI/MPC Communication

 * RBI’s approach has been different in this cycle, upfronting the easing in order to facilitate quicker transmission but then changing communication to tone down future expectations from monetary policy. The change of stance to ‘neutral’ has been done to emphasize data dependency in actions going forward. However, for the market the precise definition of ‘accommodative’ stance is option only to hold or cut whereas ‘neutral’ stance denotes option to hold, cut, or hike. The justifiable question to ask then is this: What has happened between April and June that requires bringing back optionality to hike? Follow-up communication from RBI emphasizing low current inflation basis volatile food prices, core around 4%, and future projection seeing CPI rising to 4.9% has all served to strengthen market perception that this looks like end-of-cycle commentary.

* However, there is a very strong likelihood that market has over-read commentary a bit. As discussed above, global uncertainties and the slowdown cycle seem to have some ways to go and the actual options in front of RBI are only hold or cut. Indeed, the minutes of the August policy suggest a wait and watch mode for accumulated monetary easing to pass through, with enough acknowledgement for future growth risks to keep the prospects of more monetary easing alive. Indeed, the escalation in US tariffs have heightened growth risks since then whereas the proposed GST cuts will have a salutary effect on inflation.

* All in all, we don’t think the negative effect of RBI commentary on the bond market has much further room to run. There is a strong likelihood of at least one more repo rate cut followed by a long pause. Commentary should suitably start to turn in the run up to the cut, nudged in all likelihood by growth uncertainties and the incremental benign effect on inflation from GST cuts.

* A good way to think about this in our view is to contrast current RBI approach to what may traditionally have been the approach: In the earlier approach, we may have had fewer rate cuts and liquidity injections till now, but the expectations channel would have been solidly in play: stance would probably have still been ‘accommodative’ and term spreads on the yield curve may not have been so high already. This market price action would have been more consistent with where we are in the macro-economic cycle.

4. Supply of Duration

 * It is well recognized by now that market demand has not kept pace with the rise in duration supply. Till the turn of the financial year, the duration extension was largely in central government bond supply. However, since FY26 one has seen a significant rise in average tenor of state government borrowings also. Weighted average maturity of SDL as well as quantum of issuances has risen notably this year.

* This trend has made the narrative on the long end of the curve even more binary: it will find some relief if second half borrowing calendar reduces long end supply. However, with the rise in SDL duration, the extent of this supply cut needs to be even more meaningful than before. As this narrative gains ground, the long end is at risk of reclaiming its status as an ‘exotic’ part of the yield curve as it used to before. This may reflect in declining liquidity and interest only from the ‘investor’ class.

* At the same time, given the supportive global and local macro-backdrop it is hard to significantly cut duration exposure. To reiterate, we don’t think it is time to position for end of cycle, especially from a macro-economic rather than merely a rate cut standpoint. Even with limited further rate cuts, slower lending growth will likely lead to more allocations to investment books thereby keeping demand for bonds robust (even though demand doesn’t look very robust currently).

Conclusion

In summary, we find the macro backdrop to be decidedly bullish for bonds, fiscal fears to likely not eventually amount to much though definitely bearing a watch, most of the bond market damage from revised RBI/MPC commentary and stance to have played out already, but the supply of duration definitely posing a challenge for the market especially with states having joined in to elongate issuance maturity. This paints a somewhat complex backdrop at first glance, but nevertheless has concrete takeaways for us in terms of portfolio strategies:

1. In our view it is as yet too early to adopt a full passive carry book strategy. These are more end-of-cycle plays, and with the bulk of global growth slowdown underway currently as well as local monetary policy still in play, we think we are still far from end of cycle. As noted above, ‘end of cycle’ here refers to both the monetary policy cycle as well as the bond-bullish phase of the macro cycle.

2. Recent market sell off has been across the board as participants have suffered stop losses and / or have been forced to manage market risk. Thus, for example even the 5 – 6 year bond yields have risen meaningfully. This has made very short tenor, carry oriented strategies look good on relative performance. However, as discussed here we think it is still early for end-of-cycle positioning. Therefore, we still think that government bonds offer reasonable opportunities and continue to prefer these for participation in our short duration strategies as well.

3. Given the increasingly binary commentary around the long end, and the escalation in supply of duration via SDLs as well, we find less comfort in relying on this part of the curve as a performance driver. Thus, in our active duration bond and gilt funds we have moved even more over-weight positions to the 14 – 15 year part of the government bond curve with very marginal positions in the long end as at date. While duration supply has pressured the 14 – 15 year segment as well, there are more players here and with turn in market sentiment at some point, there is good potential for yields here to compress versus the 10 year segment. Also as noted in a previous communication, the bulk of recent impact has actually been borne by this segment, thereby making relative value quite attractive here. The 5 – 8 year segment is much ‘safer’ but entails a far higher duration sacrifice than we want to make at this juncture in our active duration funds. However, in short duration funds, we are indeed overweight the 5 – 8 year segment.

We have no means of ascertaining currently how the second half borrowing calendar will get recalibrated. Our portfolio changes are basis current information and where pockets of value have emerged as discussed above. More broadly, for us and investors, the recent escalation in market volatility has been painful and it is all too straightforward to conclude that the bond cycle is over; especially as central bank commentary at face value seems to have supported that idea. However, as discussed in detail here we don’t think that is the case at all. Valuations even on relatively lower duration parts of the curve such as what is generally held in short term funds have cheapened a lot, whereas 14 – 15 year sovereign bonds are almost 150 bps over the current overnight rate. With a sufficiently long investment horizon to account for market volatility, and with enough steam left in the bond bullish part of the macro cycle, we think the market set-up provides reasonable opportunities for investors.

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