► Interest rate expectations : The month started with dovish than expected Fed policy wherein highlights were reduction in pace of Fed Balance sheet drawdown by US$ 35bn and continued focus on Inflation and incoming data. Macro data was a mixed bag but employment and inflation data came a tad softer than market expectations. Headline inflation was lower than expected at 0.1%. Based on these we retain our view that rates in US would remain higher for longer, though we believe that if data surprises on downside Fed would be looking at 1-2 rate cuts in 2024. The UK and the euro region may be the first ones to lower interest rates. Meanwhile, the Reserve Bank of India kept interest rates unchanged but upgraded the growth outlook.

► India's macro on a strong footing : The RBI paid a higher than expected dividend payout of Rs 2.1 trillion to the government, vs the expected Rs 0.9 trillion. This is likely to lead to lower market borrowings in the second half of the year and consequently lower bond yields. Furthermore, the higher dividend is positive for the government's fiscal consolidation plan per the interim budget to narrow the deficit to 5.1% of GDP in FY25. Headline inflation marginally softened to 4.83% in April however, food prices remained stubborn at 7.9% while core inflation moderated to 3.2%. Overall, both headline and core inflation have been on expected lines and with expectations of timely onset of monsoon we do not expect any upside in inflation trajectory in near term.

► Banking liquidity continues to be in deficit : Banking liquidity for month was in deficit given that April-May were the election season and as such there was a lack of government spending. In consultation with the central bank, the government announced buyback programs of short dated government bonds and also reduced size of Treasury bill auction calendar by Rs 60,000 cr to improve the banking liquidity.

► GDP growth and sovereign rating upgrade paints a positive picture : The 4QFY24 GDP growth surprised on the upside at 7.8%, even as GVA growth remained relatively muted at 6.3%. Consequently, FY2024 real GDP growth also surprised on the upside at 8.2%. The GVA-GDP gap remained wide, owing to higher net indirect taxes growth. Furthermore, S&P Global Ratings upgraded India's sovereign rating outlook to positive from stable while retaining the rating at 'BBB-' on robust growth and improved quality of government expenditure. The ratings agency said it could upgrade India's sovereign rating in the next two years if the country adopts a cautious fiscal and monetary policy that diminishes the government's elevated debt and interest burden while bolstering economic resilience.

Market view

A dovish than expected Fed's monetary policy in May, weaker macro data in the US and the RBI's surprise gift to government in form of Rs 1.25 trillion higher dividend then expected has led to rally across bond and swap markets both in the US and India. Yields are down in long tenure bonds by more than 20-30 bps in last one month. US 10-year treasuries are down from 4.75% to 4.30% and India 10-year bond yields traded below 7% after almost a year. Yields on money market (short term upto 1 year) saw an uptick earlier in the month because of tight banking liquidity which also rallied post announcement of T-bill borrowing cut and surplus RBI dividend. Government bonds and swaps outperformed corporate bonds/SDL's this month due to expected cut in government borrowing and rally in US treasuries.

We believe, in lieu of strong US and India growth, run up in commodity prices and geo political uncertainty, central banks across including RBI would not be in a hurry to cut rates. As expected, the RBI maintained a status quo in its June policy.

Short-term outlook
We expect bonds (10 year G-sec) to remain volatile and trade in a range 7-7.20%.

Fear of higher allocations to welfare schemes and higher borrowing in budget will lead markets to trade in a range. We are of the view that there will not be any significant changes in borrowing and fiscal deficit (5.1% of GDP) in final budget to be announced next month

Higher government spending and reversal of CIC will keep banking liquidity surplus in near term, which would be positive for short end of the curve (money market and short bonds 2- 4 years)

Medium term outlook
Favorable demand supply dynamics for bonds and falling CPI trajectory will slowly and gradually take bond yields to 6.75-85% range

Investors will have to be patient for further rally in yields as it would commensurate with actual FPI flows, global rate cuts in second half of the year and sustained low inflation.

Risks to view
Higher than expected borrowing announcement in budget next month

FPI outflows in near term leading to INR volatility and depreciation

Positioning & Strategy
The fixed income curve in India is pricing in no rate cuts till March 2025. We have retained our long duration stance across our portfolios within the respective scheme mandates. We do expect the 10-year bond yields to trade in a narrow range of 7.00-7.20% in the near term and to soften to 6.75% over the next few quarters. Investors need to be patient on the rate cut cycle which could be delayed to the second half of FY25.

From a strategy perspective, the overall call is to play a falling interest rate cycle over the next 6-12 months. Accordingly, investors should continue to build and hold duration across their portfolios. In addition, investors should be patient for further rally as rate cuts have been delayed to H2FY25. With positive demand supply outlook for bonds, FPI flows via JP Morgan Indices starting June 2024 and possibility of a lower government borrowing in July, investors could use this opportunity to invest in Short to Medium term funds with tactical allocation to gilt funds.

Source: Bloomberg, Axis MF Research.