Which way is the market headed?

As we say shalom to 2016, the key drivers for the markets in the year ahead have become more obvious, says Neeraj Gambhir, managing director and head of fixed income, India, Nomura.
First, there is a surging dollar.
Second, rising commodity prices.
Then, we have the effects of demonetisation.

Three negative surprises in a row, and the bond market rally has taken a pause.

First, it was the cash reserve ratio (CRR) hike by the Reserve Bank of India, then lack of a rate cut in the policy and finally, a hawkish hike from the US Fed.

Bonds have given up roughly half the gains since early November.

Even then, it has been a good year for fixed income.

After a steady decline in yields over the first three quarters, the market was in a consolidation mode.

Demonetisation triggered a sharp decline in bond yields.

Expectations started veering towards bigger rate cuts by the RBI to offset the growth slowdown, triggered by the currency crunch.

Global factors took a back seat.

Rising commodity prices and the expected 'Trumpflation' of the US economy had caused bond yields elsewhere to rise sharply.

Though the rupee weakened, the Indian bond market significantly outperformed its peers last month.

As we say shalom to 2016, the key drivers for the markets in the year ahead have become more obvious.

First, there is a surging dollar. The Trump presidency is supposed to bring large fiscal support to aid growth. It could also lead to higher inflation.

As the US Fed has sounded more confident about economic recovery, the market's faith in the dollar has found a new tailwind.

We expect the rupee to weaken further. But, as has been the case last year, it is likely to continue outperform its peers.

Second, rising commodity prices, including crude oil, could pose a challenge for our external account and inflation expectations.

Typically, a strong dollar means weaker commodity prices. However, and since we are talking about reflation, it will not be wise to take that for granted.

If commodity prices rise significantly, combined with weakening currency, it will be a double whammy.

Then, we have the effects of demonetisation.

Less or virtually no cash in the hands of the public has meant growth has taken a beating.

In some sectors, perishable goods, for example, prices have declined significantly.

The inflation reading for last month surprised on the downside, largely driven by this effect.

The question is how much of this demand shock will sustain.

Will we see a more enduring impact on inflation?

Just as the equity market is driven by growth, the bond market obsesses about inflation.

If the sobering effect on inflation sustains, the RBI will have more headroom to pursue its easy monetary policy.

Demonetisation has also led to a sharp increase in liquidity with the banking system.

Cash withdrawal is still restricted. So, banks are pondering over persistence of this liquidity.

As the economy transitions to digital payments, a significant part of this liquidity should stay back, even after the constraints are lifted.

In the absence of meaningful credit demand, banks will look to invest this money in the bond market.

Money should also start flowing into other investment vehicles, such as mutual funds.

That will also have a salutary effect on fixed income as an asset class.

The Government bond yield curve has already discounted some of it.

The spread between long bond yields and the overnight rate has narrowed a lot.

While the global backdrop doesn't look as good, liquidity is likely to support the benchmark yield curve.

We expect corporate bonds to fare a lot better as the market consolidates and looks for yield pick-up in the coming months.

Photograph: Kind courtesy 401(K) 2012/Wikimedia Commons