How much longer can the bond rally continue?
To answer the question, we have to determine what is fuelling the rally.
The current rally in the government bond market has been the longest since the global financial crisis and despite intermittent caution setting in, the fall in bond yields has persisted.
The benchmark 10-year bond yield dropped over 60 basis points (bps) between April and October. One basis point is one-hundredth of a percentage point.
But what really egged on the rally was the government’s move to withdraw the high value bank notes.
The currency withdrawal has led to banks being flush with an unprecedented amount of deposits.
With credit growing at a glacial pace of sub-6% amid this deluge of deposits, banks could do nothing but put these into government bonds, thus making yields nosedive 40 bps in two months.
The banking system’s holding of sovereign bonds under statutory liquidity ratio (SLR) has reached 34%, far higher than the mandated 20.5%.
This means that around Rs1.5 trillion worth of bonds that banks are holding is simply because of no other return generating avenue.
Even in the best of times for liquidity and bonds, the systemic SLR level hasn’t crossed 30% in a long time.
What may change over six months is that cash withdrawals will pick up pace and bring down the deposit accretion in banks.
Most analysts expect not more than 30-40% of the roughly Rs14 trillion worth of old bank notes to turn into durable deposits for banks.
Loan disbursals are bound to pick up although they may not dramatically.
Given these twin events, the appeal of bonds to banks will wane.
The second leg of the rally has been the Reserve Bank of India’s bond purchases through open market operations (OMO).
In its commitment to bring liquidity to near-neutral levels, RBI earnestly began buying bonds from April onwards and has so far purchased more than Rs1 trillion worth of bonds through OMO auctions.
This is roughly a quarter of the total government borrowing for fiscal 2017.
It is unlikely that the central bank would feel the need to keep buying bonds as liquidity is now copious.
Analysts at Standard Chartered believe the demand for bonds from RBI will disappear but banks, being captive investors, would still absorb more than 45% of the net supply.
But the bond market rally has one too many legs as bonds react to macroeconomic data more swiftly than any other market.
So, favourable retail inflation readings, a possible weakening of gross domestic product growth will cheer bond investors.
The next big movement, of course, would be from the Union budget. Bond investors are keen to see the contours of the government’s spending and its market borrowing.
But all these factors aside, bond yields are near their floor as changing demand dynamics will soon trigger repricing.