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Informist, Wednesday, Jan. 1, 2025

 

By Aaryan Khanna

 

NEW DELHI - In hindsight, bond traders look back at 2024 with a feeling that the best conditions for gilts are now behind them. While the promise of interest rate cuts in the near future offers hope, traders think 2025 will be complicated by increasing uncertainty from the US.
 

Yield on the 10-year benchmark government bond fell from as high as 7.24% in January 2024 to a low of 6.65% in December, summing up the bounty bond traders reaped in 2024. While the fall in yields was punctuated by some volatility due to rate cut views shifting back and forth, optimists in the market see yields falling to as low as 6.10% in the new calendar year. However, pessimists fear the era of 7.00% may return if the Reserve Bank of India does not oblige and lower the repo rate.

 

The baseline scenario, though, is one of the Monetary Policy Committee beginning its rate-easing cycle in February at newly-appointed RBI Governor Sanjay Malhotra's first meeting, who is viewed as more growth-supportive than his predecessor, Shaktikanta Das. With growth faltering alarmingly in Jul-Sept and the outlook for inflation reasonably favourable--the RBI sees CPI inflation averaging 4.0% in Jul-Sept, in line with its medium-term target--expectations are built in for a 50-75 bps reduction in the repo rate in 2025. This could help bring down the 10-year bond yield to around 6.40%.

 

SUPPLY AND FLOWS

For yields to fall below 6.40%, much will continue to depend on the demand-supply dynamics, dealers said. With the government well on track to meet and possibly even undershoot its fiscal deficit target of 4.9% of GDP for 2024-25 (Apr-Mar) and achieve the medium-term roadmap of reducing the deficit to under 4.5% in FY26, the net supply in the next financial year is seen around FY25 levels.

 

In terms of local demand, traders point to the ever-increasing might of the retirement industry--life insurers and pension funds--and their need for high-quality, fixed-income assets. "The long end demand-supply picture will remain just as good in 2025, because duration supply is likely to be similar to 2024 while the demand from retiral funds is expected to grow by at least 12-15%," said Churchil Bhatt, executive vice president-investment, Kotak Life Insurance Co.

 

Demand from overseas, however, could be problematic. In 2024, foreign portfolio investments into Indian debt amounted to $20 billion--of which $18 billion was in gilts foreign investors can buy without restrictions--despite a lean December quarter. It is unlikely that 2025 will see such hefty flows even though the internationalisation of India's bond market is set to continue in 2025 with the inclusion of sovereign bonds into the emerging market bond indices of J.P. Morgan, Bloomberg, and FTSE Russell.

 

Unlike the inflows linked to the large J.P. Morgan index, which started in June, incremental inflows tied to the other two indices may total less than $8 billion, as per dealers. Further, discerning investors may turn their backs on emerging market fixed-income assets if US Treasury yields rise as expected due to the expansionary policies of the incoming Trump administration and the Federal Reserve sticking to its guidance of only a 50 bps reduction in interest rates. With the spread between 10-year bond yields in US and India already at a two-decade low, foreign investors' appetite for gilts in 2025 may not match that of 2024.

 

DOUBLE-EDGED LIQUIDITY SWORD

After exhibiting exceptional stability for much of 2024, the Indian rupee has hit multiple fresh record lows in recent weeks, weakening by around 1.8% against the US dollar in Nov-Dec compared to a 1?ll in the 12 months ended October. Further depreciation is seen putting off FPIs not just because of the currency risk but also the possible monetary policy implications of imported inflation.

 

"Persistent INR depreciation and delay in the rate easing cycle would be a setback for the bond market in near term," Pankaj Pathak, fund manager – fixed income, at Quantum Asset Management Co, said in his outlook for 2025. "However, with liquidity situation getting tighter, there is a possibility of RBI conducting OMO (open market operation) purchases of government bonds to provide durable liquidity in coming months. This would be supportive for the medium-to long-duration bonds."

 

With the RBI having already reduced the Cash Reserve Ratio by 50 bps to the pre-pandemic level of 4.00% of banks' net demand and time liabilities, traders are increasingly hopeful the central bank will be forced into conducting OMO purchases to the tune of as much as INR 1 trillion in 2025 to shore up systemic liquidity that has been drained by its interventions in the foreign exchange market to shore up the rupee.

 

POTENTIAL WILDCARDS

Among the potential unknowns is the possibility of India being added to the Bloomberg Global Aggregate Index, which could lead to inflows on par with what the J.P Morgan index inclusion brought in. While the index provider's investors may seek access to India's large market, some sections of the market think it may be too early. The addition to Bloomberg's emerging market index, which begins January for India, is being seen as a trial before the main index inclusion.

 

The proposed tweaks to banks' Liquidity Coverage Ratio norms also bode well for gilts in 2025, although traders increasingly think the RBI will not enforce the draft guidelines starting Apr. 1. But if these norms come into force, analysts think they could create additional demand of up to INR 4 trillion for gilts, although some of these purchases have already been made by banks.

 

The one negative wildcard that could play spoilsport is upside risks to inflation forcing the MPC to not cut the repo rate at all in 2025. Moreover, should growth recover after a disastrous Jul-Sept--as the RBI and the government both expect to be the case--the MPC could choose to keep its powder dry. According to Axis Bank Chief Economist Neelkanth Mishra, the MPC may not cut interest rates at all this year as food inflation may keep the headline elevated while GDP growth may rebound to 7.0% in FY26.

 

On the whole, bond traders are looking forward to a profitable 2025. But there is also a sense this is the beginning of the end for the purple patch in gilts.  End

 

US$1 = INR 85.70

 

Edited by Vandana Hingorani

 

 

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