Blame Lentils for Putting Brakes on India's Sovereign Bond Rally

  • DSP BlackRock sees inflation upturn limiting room to cut rates
  • Consumer prices rise by most in three months in September

Indian bonds came off the rails in October after a three-month rally. And investors can blame the lentils.

While the outlook for higher U.S. interest rates scared away some emerging market fund managers, the rising price of the edible seeds that are a staple of the Indian diet threw a fresh ingredient into the mix. Lentils surged 30 percent in September, fueling a 4.41 percent increase in the consumer price index, of which food accounts for almost half. 

Rising food costs coincided with a sell-off in rupee bonds that drove up the yield on benchmark 10-year bonds by 10 basis points during October. And for DSP BlackRock Investment Managers Pvt, a unit of the world’s largest money manager, worse is to come, as the Reserve Bank of India balks from cutting interest rates further.

“Inflation is likely to trend higher from here,” said Dhawal Dalal, Mumbai-based head of fixed income at DSP BlackRock. “This will perhaps reduce headroom for the RBI to cut aggressively going forward. Moreover, as and when the Federal Reserve begins to raise rates, market volatility may impinge on the RBI’s rate decisions.”

Dalal predicts the yield will climb as high as 7.70 percent by Dec. 31 compared with its earlier forecast of 7.50 percent and the 7.45 percent median estimate in the latest Bloomberg survey of analysts.

Lentil costs surged following a poor monsoon that parched vast tracts of farm land, and Prime Minister Narendra Modi’s administration plans to build up a buffer stock of pulses from imports to help restrain prices in future. The government has already imported 5,000 tons of pulses with another 2,000 tons to arrive soon, Finance Minister Arun Jaitley said last month.

While inflation remains below the central bank’s target of 6 percent by January, it’s set to accelerate early next year as the government prepares to increase salaries for its employees.

“We expect inflation to average between 5 and 5.3 percent in 2016 unless we see further correction in commodity and food prices,” said Dalal of DSP BlackRock. The impact of higher salaries on consumption will lend an “upward bias” to consumer prices, he said.

RBI Governor Raghuram Rajan, who has cut borrowing costs by 125 basis points in four moves this year, will keep them unchanged till the end of 2016, according to a separate Bloomberg survey.

Sovereign bonds retreated last month as the Fed’s indication that it may raise rates as early as December unnerved investors. The benchmark 10-year yield climbed 13 basis points from a two-year low of 7.51 percent on Oct. 5.

Higher debt supply also boosted yields, according to SBI Funds Management Pvt. The issuance of 750 billion rupees of government debt in October was the biggest since May. Bonds fell even as authorities allowed global funds to increase their holdings by as much as 130 billion rupees ($2 billion) by December, part of a wider opening that aims to attract 1.2 trillion rupees into debt by March 2018. Foreigners have used up about 99 percent of the existing debt quota and inflows can only pick up when the ceiling is next raised in January.

“Higher bond sales and no fresh foreign limits till January are weighing on market sentiment,” said Rajeev Radhakrishnan, Mumbai-based head of fixed income at SBI Funds, a unit of India’s largest lender.

Foreign holdings of all rupee-denominated debt peaked at 3.56 trillion rupees on Oct. 26 and declined over the next four days, data from National Securities Depository Ltd. show.

“An environment of uncertainty is making investors cautious,” said Ankur Jhaveri, co-head of currencies and rates at Edelweiss Financial Services Ltd. in Mumbai. Bonds are likely to remain lackluster for want of any major positive developments on the horizon, he said.

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