Investors in Indian government securities have had it pretty good over the past year. Prices have been increasing steadily as the Reserve Bank of India (RBI) first cut rates in April 2012 and then resumed monetary easing in January. The repo rate has come down by 125 basis points since then and yields on government securities have followed suit. As equities have performed reasonably well over the past few months, investors must wonder whether the time is right to exit their bond positions and try and take advantage of the momentum in equities. What are the prospects for further increases in bond prices?
Two significant factors will determine the future course of prices. First, it will be driven by further rate actions by the RBI. Some indicators do suggest that more cuts are likely. Core inflation had declined quite significantly, which signals the complete absence of demand pressures. This is, of course, borne out by the slow growth in industrial production and sluggish corporate performance. Further, the softness in commodity prices overall, but particularly in crude oil, is proving to be quite persistent, which should also reduce the pressure on inflation. But these factors are offset by high headline inflation, particularly as reflected by consumer prices. The influence of the softening in the prices of some food items has been more on wholesale price measures than on consumer price measures of inflation. This only serves to maintain the pressure on inflationary expectations, thereby limiting the room for more easing. In fact, the RBI’s annual statement, presented earlier this month, projected that the inflation rate would harden somewhat in the second half of the year and statements from the RBI governor repeatedly emphasise that they see very limited room for further easing.
Second, given the monetary policy stance, the fiscal position will also have an influence. It is unrealistic to expect a dramatic change in the fiscal situation, which can sharply reduce the supply of bonds, thus driving their prices up and benefitting investors. But the opposite scenario, in terms of increased borrowing requirements, is conceivable. This would actually drive yields up, pushing prices down. In a typical pre-election scenario, the likelihood of this happening may increase, but in the current circumstances, the government seems quite committed to keeping a tight lid on expenditures in a bid to reassure both investors and rating agencies that it is serious about fiscal consolidation. Given this, at least in the next few months, the supply of bonds is likely to adhere to the borrowing plan for the year. The implication of this for bond prices is that they will remain relatively stable. Putting the two together, the logical expectation is that prices are close to their peak, with some headroom provided by the prospect of further easing by the RBI, even if it is limited. But the risks of a sharp fall in prices are low, because the prospects of unanticipated increases in the supply of bonds are quite low. All told, this is not a bad position for investors to be in, particularly when many analysts are indicating that equity markets are also approaching peak levels.
