Global Overview

• US Treasury yields remained volatile over the last month, responding to a mixed bag of economic data, strong corporate earnings results, and speculation over the Fed’s commentary at the May meeting. As expected, the Fed  hiked interest rates by 25 bps at the May FOMC meeting, while maintaining a dovish tone. The reference to ‘additional policy firming’ was dropped, suggesting a possible end to the hiking cycle. Regarding the state of the economy, the central bank highlighted that wage growth and job openings have cooled off, without an increase in unemployment, indicating that the US may avoid a deep recession this year. More importantly, Chair Powell pushed back on the possibility of rate cuts in 2023, stating that they don’t expect inflation to come down soon enough to warrant such a move. However, markets seem to disagree and have priced in 75 bps of rate cuts this year.

• On the data front, although recent inflation eased to 5% y-o-y, the Fed’s preferred gauge i.e PCE and core PCE came higher than market expectations (4.2% and 4.6% y-o-y vs estimates of 3.7% and 4.5%, respectively).Nonfarm payrolls rose 253K in April, surpassing estimates of 180K, while job openings cooled to a near-2-year low in March. Meanwhile, the latest private payroll additions came in above forecasts at 296K in April, and the unemployment rate edged lower to 3.4% in April from 3.5% in the previous month. Even as Q1 2023 GDP grew 1.1%, below market consensus of 2.2%, robust consumer spending is what kept the economy from contracting. Improvement in service sector activity (services PMI at 53.7 in April vs 51.5 consensus) pointed to a still-healthy economy.

• Looking ahead, we believe the change in the Fed’s forward guidance indicates that future policy moves could be data-dependent, as the full impact of the cumulative 500 bps rate hikes continue to work through the economy. If incoming data turns out to be stronger than market expectations, rate cut expectations will continue to get priced out which may see the shorter end of the yield curve moving higher. While data will continue to play a crucial role in policy expectations, we also remain watchful of resurfacing concerns of banking system instability. Additionally, stalemate over the revision of the debt ceiling limit, as we near the funding deadline of June, will be a lingering concern.

• A hawkish ECB policy meeting, subdued growth and stickier-than-expected inflation dominated European bond market performance over the past month. While ECB hiked the policy rate by 25 bps, its smallest increase in the current tightening cycle, President Christine Lagarde sent a hawkish message of keeping the door open for future rate hikes given that the “inflation outlook continues to be too high for too long”. Recent data also confirmed that underlying inflationary pressures were stickier than expected. Core inflation fell only slightly in April to 5.6% y-o-y from a record 5.7% a month ago, while CPI came in 10 bps higher at 7%.

More notably, the minutes of the March meeting acknowledged that inflation has shifted from a supply-side issue to a demand-side issue, convincing of a sluggish return to the 2% target. On the growth front, weak-but-positive GDP growth data also supported the case of a 25 bps rate hike. Q1 GDP grew 0.1% y-o-y, missing market estimates of a 0.2% rise, after flatlining in the previous quarter.

• It is unlikely that the ECB would go back to 50 bps rate hikes in the current scenario. We expect the ECB to continue with another 25 bps rate hike in June, following which it could prefer to assess the impact of ongoing transmission of past rate increases. The stop to Asset Purchase Program (APP) reinvestments from July also hints towards the same, which could limit the retreat in European bond yields.

• Double-digit inflation and relatively tight labour markets have built the case for a hawkish Bank of England policy in May. CPI and core CPI rose 10.1% y-o-y and 6.2% y-o-y in March, beating market estimates of 9.8%, and 6%, respectively. More notably, BoE officials too supported the case for tightening until inflation was seen moving towards the 2% target. The better-than-expected gain in the number of employed persons (169K in 3 months ending February vs 50K estimate) and healthy wage growth (6.6% y-o-y in February vs 6.2% estimated) provided continued evidence of strong inflationary impulses. Meanwhile, GDP growth in the 3 months ending February rose 0.1% after remaining unchanged a month prior. Other high-frequency indicators such as retail sales (-3.1% y-o-y in February vs -3.3% prior), industrial production (-3.1% y-o-y in February vs -3.2% prior) and services PMI (preliminary estimate of 54.9 in April vs forecast) too pointed to a slight improvement in the economy.

• At the current juncture, while there remains the possibility of another 25 bps rate hike in May, it is likely that BoE will maintain a relatively tighter monetary policy compared to its developed market peers, raising rates at the June meeting as well. As a result, UK gilt yields could move higher from current levels, easing only once the broader effect of tightening credit conditions begin playing out and the peak rate is in sight.

• In his first policy meeting Governor, Kazuo Ueda decided to continue with a dovish monetary stance and announced a comprehensive review of the BoJ’s policies. BoJ dropped part of its forward guidance that previously said it “expects short- and long-term policy interest rates to remain at their present or lower levels”. Ueda justified the ultra-loose stance at the current juncture stating that the risk of premature tightening was currently higher than the risk of inflation getting out of control. In its economic outlook report, BoJ made an upward revision to its inflation outlook. It projects that consumer prices for the current fiscal year 2023 will be 1.8%, compared with 1.6% in the previous report, while the core inflation forecast was revised significantly higher to 2.5% from 1.8% in January.

• On the data front, both CPI and core CPI beat market expectations (3.5% y-o-y in April vs 2.6% forecast and 3.8% y-o-y in April vs 2.9% forecast, respectively), while wage growth remained unchanged at 0.8% in March, missing estimates of a 1% rise. BoJ has suggested it could take 12 to 18 months to review the existing policy, also stating that the Board would continually assess whether a policy change is needed. Hence, we believe that the latest data could prompt a revision in the YCC policy in the coming months. A rate hike this year would however remain contingent on whether inflation and wage growth runs hotter than BoJ’s outlook.

India Overview
• India’s 10-year benchmark bond yield eased 26 bps over the last month to a one-year low of 7.02%, on bets that the Reserve Bank of India (RBI) has reached its peak policy rate in the current tightening cycle. Expectations of a potential pause in the Fed’s rate hike cycle going ahead and a sharp fall in crude oil prices also boded well for domestic yields. Rates at the shorter end of the curve however remained elevated as surplus liquidity conditions tightened. Banking system liquidity remained in surplus for most of April on account of government spending and RBI intervention in the FX market. However, LTRO/TLTRO redemptions, GST flows and RBI’s VRRR auction worth Rs 1.53 lakh crore brought liquidity close to neutral.

• Minutes of the April MPC meeting showed that members were conflicted over growth and inflation dynamics. While inflation was expected to move lower over the coming months, members acknowledged uncertainty over monsoons and elevated oil prices in international markets as a key risk to the outlook. We believe that average CPI inflation will ease to 5.1% in FY24 led by lower food and core inflation as the impact of previous rate hikes plays out. Most members remained optimistic about growth prospects (evident from the upward revision of GDP growth to 6.5% in FY24) on the back of the government’s infrastructure and investment thrust and waning pressures from the external sector. However, Professor Varma and Dr Goyal believed that a slowdown was underway. Dr. Goyal also pointed out that as per an RBI study, the impact of interest rates is asymmetrically high on growth than on inflation. We expect GDP growth at 6.1% in FY24. With retail inflation likely to remain above the 4% inflation target of RBIs, we do not foresee any rate action in the current fiscal year.

• As per CareEdge’s latest report on El Nino and Its Impact on Indian Economy, the possibility of a below-normal monsoon this year hinges on a combination of several factors such as the timing and intensity of El Nino and the strength of positive Indian Ocean Dipole (IOD). Additionally, the impact on agricultural production will depend on the spatial and temporal distribution of rainfall. As per the report, due to the sizable diversification of the rural economy towards non-farm sectors, the overall impact on rural demand and GDP is expected to be limited.

• Incoming bond supply and potential weather-driven disruptions could put upward pressure on bond yields during FY24. However, we expect the 10-year benchmark bond yield to remain around 7% by end-FY24 on the back of rising bets of a policy pivot amidst easing inflation and moderation in growth.