Introduction
The bond market remained under pressure during the month largely owing to expansionary fiscal policy & higher borrowing in the Interim budget. The old ten year benchmark bond yield (7.17% GOI 2028) ended the month 11bps higher at 7.48%. The new ten-year benchmark bond yield announced on 11th January’19 came in at a coupon of 7.26% and ended the month 2bps up.
The Interim Budget largely delivered on the reflationary stimulus that was being anticipated. The budget postponed the fiscal consolidation targets again. FY19 Revised Estimate (RE) fiscal deficit came at 3.4% of Gross Domestic Product (GDP) (vs. FY19 Budget Estimate (BE) of 3.3%) and FY20 BE fiscal deficit also at 3.4% of GDP (vs. previously assumed 3.1% as per the glide path). While there is a component of GST shortfall that has weighed on this consolidation, the next year’s revision is wholly owing to the new consumption stimuli embedded in the budget. When combined with state deficits as well as the heavy reliance on borrowing by public sector companies lately, this again proves that fiscal remains India’s weakest macro point. The gross scheduled borrowing number at INR 7,10,000 crores is higher than market consensus expectations of around INR 6,50,000 crores. Again, combined with state and PSU borrowings this implies that bond market will likely have to contend with risks of crowding out, once RBI’s pace of open market operations (OMOs) tapers down the line. There is a hefty almost 0.6% GDP worth of new announcements between the income support plan and the tax breaks for middle class which is almost entirely of the nature of a consumption stimulus. Indeed, while total spending via the budget is slated to grow at 13.3% next year (which is lower than the 14.7% done this year), the spending mix is now skewed heavily in favor of revenue spending.
Index of Industrial Production (IIP) for November fell sharply to 0.5% after a robust 8.4% seen in Oct18. While the Nov data was expected to soften partly reflecting an adverse base-effect, the substantial downside was a surprise as the decline was fairly broad-based. Around 13 of the 23 sub-sectors under manufacturing production contracted. Consumer Price Index (CPI) inflation for Dec’18 fell further to 2.2% vs. 2.3% last month, on account of continued deflation in the food group while core inflation was unexpectedly high at 5.7%. High core inflation was on account of MoM rise in miscellaneous inflation led by health and education, even while transport component fell sharply (as expected). This was primarily on account of a sequential pick-up in rural inflation in the health and education sub-groups, even while inflation in the corresponding urban components remained subdued. The Central Statistics Office released the First Revised Estimates of National Income for FY18 along with Second Revised Estimates FY17 and 3rd Revised Estimates for FY16. FY18 GDP growth was revised up 0.5% to 7.2% while FY17 GDP growth was revised upto 8.2% (Prev.7.1%) Both private & government consumption growth were revised up by 0.9% and 4.1%, respectively while Gross Fixed Capital Formation growth was revised upwards by 1.7%
RBI in its 7th February policy meet cut policy rates by 25bps to 6.25% (voted 4-2) and changed the monetary policy stance from ‘calibrated tightening’ to ‘neutral’ (unanimous vote). The rate cut decision taken by the MPC is understandable, although market (including ourselves) had assigned a less than even chance of that happening in February largely owing to the context provided by the Budget and the expectation that the recent jump in core CPI, although owing largely to rural health and education, may cause RBI to take more time it its assessment. However, the cut can be justified owing to the persistent undershoot in headline CPI as well as more sanguine global environment, including worries on global growth.
Outlook:
With the recent rate cut, the obvious implication is for the yield curve to steepen as the market is called upon to take higher supply at the duration part of the curve. In duration our preference would be for quasi like State Development Loans (SDL) and corporate bonds rather than government bonds. While supply there is a near term problem, it typically dissipates into the new financial year. Also, starting spreads there are already reflecting higher supply. The most sustainable trade, however, is in 2-5 year AAA corporate bonds.

Source: Bloomberg, RBI, Budget documents, Ministry of Commerce and Industry, Mospi.nic.in