In this environment, economies with large fiscal and current account deficits will inevitably face higher funding costs. India is one such economy. The world of cheap money is no more. This means there will be a more urgent need for prudence. Political exigencies ahead of the 2019 election would likely add to the complications for India. We expect Indian bonds to come under pressure from rising global yields, higher domestic inflation — already the April consumer price inflation (CPI) data surprised to the upside — increasing pressure for the RBI to hike rates in the second half of 2018 and possibly a larger bonds issuance plan to all push Indian yields higher in the months ahead. Failure to hike rates in the second half of CY18 would be good for Indian equities in the immediate term, but not for bonds.
The RBI is banking on a normal monsoon and benign inflation as regards key interest rates. How realistic are the forecasts?
With some luck on the weather, India has been very successful in keeping food prices under control in recent years. This may have encouraged the RBI to price in lower risks of large food inflation in the months ahead. We understand such a view. As always, when it comes to the monsoon though, the tail risks are large. The doubling of global oil prices too may contribute to food production costs. Trade disputes, too, may mean large shifts in China’s demand, which could alter global food prices. Without considering weather-related risks, we think these factors are likely to mean asymmetric risks to the upside in food prices in the months ahead.
What’s your view on inflation in India?
Macquarie expects headline inflation to average 4.7 per cent this year but with a clear upside risk (more so in the core measure from our 6 per cent forecast). We expect the RBI to hike key rates twice in the first half of calendar year 2019 (1HCY19). But the risks of an earlier hike are rising, especially after the overshoot in the April inflation numbers.
How do you see the global bond markets playing out over the next three-six months?
Macquarie expects bond yields to continue to rise globally over the next three-six months, driven mainly by rising inflation — albeit gradual — in most parts of the world, in particular the US. Global economic recovery boosts demand, which will, in turn, guide general prices higher. Rising oil prices are also a subtle but important supply-side driver. Essentially, we expect the US Federal Reserve to hike rates four times this year, guiding US Treasury bond yields higher, and pushing up global yields in the process.
Are the equity and bond markets factoring in four rate hikes by the US Fed at this stage?
We think the market is pricing in only one hike short of these projections per year. If we are right, short-end yields will likely have 25-50 basis points (bps) upside room from here. But we see further upside in long-end United States Treasury (UST) yields, as growth and inflation are repriced.
As yields rise and bonds become cheap, equities will look relatively expensive. This will cap equity indices this year. But growth and earnings projections remain positive, providing enough cushion to equity prices to be less sensitive to bond yield moves. We, therefore, see greater risks of adverse price action on the latter than the former for the next three-six months.