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Investment Insights

Suyash Choudhary

Our Assessment Framework
 
Over the past few months, we have been highlighting our framework for assessing RBI policy and bond market outlook. Briefly the key features are as follows:
 
1. RBI is committed to lowering headline CPI along a glide-path that sees inflation at 8% by January 2015 and at 6% by January 2016. Subsequent ‘targets’ may be set in consultation with the new government. Given this commitment, the central bank will closely look at the underlying momentum in CPI inflation irrespective of near term volatilities in the headline reading due to seasonal or transitory factors. The importance of this framework has to be understood in context of fixing a now almost chronic problem of low domestic financial savings to GDP ratio, in an environment where global capital may become increasingly more volatile.
 
2. RBI’s liquidity philosophy has moved towards restricting liquidity available at the repo overnight window. Instead, it now provides additional liquidity via variable rate term repos. This means that average overnight rate is no longer pegged at repo rate but hovers 25 – 75 bps higher than the repo rate depending upon the banking system’s liquidity requirements. The specific implication for investors is that the so-called term spread when buying longer duration bonds no longer looks as attractive as it would when compared with the repo rate.
 
3. Banks have suffered significant losses on their investment books since mid-July. This could likely impact their appetite for continually running SLR positions much in excess of their ‘held to maturity’ investment limits. If true, this in turn could show as some fatigue in absorbing the new financial year’s supply calendar of government bonds. Additionally, the gross bond supply number itself may get revised up once the full year budget gets restated by the new government.
 
Updating for Recent Developments
 
1. Incremental news on inflation has not been positive. Apart from the normal upward seasonality in coming months, recent disruptive weather in parts of the country has already started pushing up prices of some primary articles including vegetables. The downward trajectory in sugar prices in place since late 2012 seems to be reversing and is yet to fully reflect in CPI numbers. Seasonally adjusted momentum on core CPI remains sticky even as the headline print has softened somewhat. Finally, global weather agencies are warning of an El Nino phenomenon this year which may result in deficient rains. Our own met department is forecasting somewhat sub-par monsoons with a higher than even chance of an El Nino developing. These combined have put in place an upside risk to the near term inflation trajectory. On the positive side, if the new government indeed shows strong commitment to supply side measures, it can potentially take away some of RBI’s burden and help achieve the targeted disinflationary path without further monetary policy action.
 
2. It may be recalled that the RBI further restricted liquidity at overnight window to 0.25% of NDTL of banks (approximately INR 20,000 crores)in the April policy. As a result, even with liquidity deficit halving from around INR 2,00,000 crores as at mid-March to INR 1,00,000 crores towards mid April, overnight rates have continued to be volatile; averaging more than 8.5% for April. Besides, the central bank has also restricted FIIs from making incremental investments in treasury bills. This, along with volatility in overnight rates, has ensured that treasury bill yields have remained in the 8.8 – 9% yield band. Thus term spreads have remained unattractive for duration investors whether looked at versus overnight rates or 3 month / 1 year treasury bill rates.
 
3. After some hiccups at the start of the new auction calendar, banks have shown reasonable appetite to at least replace maturing bonds with new ones (it may be recalled that the month of April saw bond maturities of INR 40,000 crores). This has lent some stability to yields with the market now largely flat versus March; having reversed the spike in yields witnessed over the first 15 days of April. Investors have also been nudged by an expectation that a favorable election outcome may cause yields to rally on better macro-economic stability and stronger fund flows.
 
Takeaways
 
We had aggressively cut duration since mid-January as the new assessment framework got clarified and using the rally in bond prices in place then. Given developments in light of this framework as assessed above there is no reason to fundamentally change our position. However, there is one development to take account of : supply absorption thus far has proceeded relatively smoothly. This fulfills the first initial trigger to rotate somewhat into duration and respecting this, over the past few weeks, we have gradually built some incremental positions in government bonds in our bond and gilt funds. However, it must be remembered that supply absorption may yet become a challenge especially as net supply picks up from second half of May and peaks at INR 70,000 crores in August. The next two triggers to look for are as follows: One, the extent to which the new government brings complementary supply side policies to ease RBI’s burden. The context, as mentioned above, is also that of possible near term upside risks to inflation. Two, the announcement of the restated full year budget and possible increase in borrowing calendar. These will inform how we manage duration over the next few months.
 
From investors’ perspective, it is important to focus on the medium term picture. Taking average annual CPI inflation and 10 year government bond yield as anchors, it can be readily seen that the so-called ‘real yield’ has been negative for the past five years or so. Finally, RBI’s monetary policy framework has fallen in place to bring CPI down and it is likely that the government in the future will further aid this process. This is finally resulting in positive real yields and the positive gap is only likely to increase further over the next few years. This phenomenon provides a strong incentive to the long term bond investor. However, what is also true is that the adjustment phase to this new reality is still ongoing and may require continued navigation via active duration management till it is complete. Our philosophy of active management is essentially aimed at navigating this adjustment process till we are convinced that market risk-reward allows for secular long duration positions to be in place. However, it is important to emphasize that while we navigate actively, investors should approach bond funds as long term asset allocation vehicles.
 

Disclaimer:
 
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
 
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency and should not be treated as endorsement of the views or as an investment advice. The information/recommendation provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The decision of the Investment Manager may not always be profitable, as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends.This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. This update has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither the IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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Suyash Choudhary

The RBI kept all rates unchanged today, as was widely expected. However, it reduced liquidity available under overnight repo by 0.25% of NDTL of banks and moved this amount to the 7 and 14 day term repo window. The central bank’s assessment on various parameters is as under:
 
1. Growth: Global growth has started the year on a weak note, but is likely to pick up for the rest of the year. However, risks are tilted to downside. Domestic growth continued to be subdued in Q3 and despite some momentum in recent data, industrial activity remains a drag and boost from agriculture seems to be waning. Moreover, outlook for 2014 south-west monsoon appears uncertain. Nevertheless, and contingent upon inflation falling, the RBI expects growth to pick up from ‘a little below 5%’ this fiscal year to 5 – 6% next year. Having said that, it acknowledges downside risks to the central forecast of 5.5% as lead indicators for manufacturing and services remain subdued, and agricultural production outlook remains uncertain on monsoons. However, some pick up may be forthcoming from some recent easing in supply bottlenecks and if export growth picks up again in line with the global growth outlook.
 
2. Inflation: CPI inflation has continued moderating driven largely by sharp fall in food prices, although the RBI notes that prices of fruits, milk, and products have started to firm up again. Also, the stickiness of core CPI around 8% suggests ‘some demand pressures are still at play’. The central forecast by January next year is pegged at 8% (in line with the recommended ‘glide path’ of the Urjit Patel committee). However, very importantly and notwithstanding the linear disinflation process that many analysts seem to be currently forecasting, the RBI sees risks to the 8% forecast stemming from sub-par monsoons, uncertainty with respect to administered price setting (MSP, fuel, fertilizer, electricity), outlook for fiscal policy, and geo-political triggers which may impact commodity prices. Equally importantly, the policy emphasizes the need to look through transient factors like a favorable base effect which may temporarily soften inflation during 2014.
 
In terms of policy guidance, the RBI reiterates that stance will be firmly focused on achieving the disinflationary glide path that sees CPI at 8% by January 2015 and 6% by January 2016. At this juncture, it assesses it appropriate to hold rates at current level, allowing previous tightening to have effect in the economy. Moreover, it guides that if inflation continues along intended glide path, further tightening is not anticipated at this juncture.
 
Interpretation and Assessment
 
It has been somewhat surprising to us to see recent debate in general media speculating on when the RBI may be able to undertake rate cuts. Presumably this debate largely rests on the straight line fall in CPI inflation over the last few months which has taken the current headline CPI very close the central bank’s first year target of 8%. In our view, this debate ignores two very important factors: One, CPI trajectory going forward may become volatile on account of seasonal pressures on primary articles’ prices, weather related disruptions etc. Two, this debate ignores the year 2 glide path of achieving 6% headline CPI. Given the lags in monetary policy (which is a primary reason for RBI going on hold currently) the RBI will need to be very sure that conditions are in place for achieving 6% CPI before embarking upon any sort of monetary easing. A point worth noting here is that Deputy Governor Urjit Patel assess that India’s potential output growth may have dipped to below 6% currently from 8.5% in FY12. Any resurgence in growth, as expected by many towards second half of this financial year, may reduce the output gap further in the first instance before supply side measures increase potential output growth over a longer period. This may put some upward pressure on demand side inflation later in the year and may require RBI to do more in order to achieve the year 2 glide path on inflation. Another risk, as mentioned in the policy as well, is what sort of a fiscal compression plan the new government puts up. Again, the RBI will evaluate this in context of achieving year 2 glide path.
 
The point we are making here is that RBI policy should not be looked at as reactionary to the past few data points. Instead, in our view, one has to focus on the underlying policy framework which in turn is focused on achieving a set of medium term outcomes. In this instance, that outcome is achieving a sustained 2 year glide path towards headline CPI inflation of 6%. The important objective behind achieving this outcome is better macro stability as financial savings to GDP improves, which in turn will benefit both the current account deficit as well as the domestic credit to deposit ratio of banks. As we have said in previous notes, purchasing this macro stability is even more critical now as global capital moves towards expecting incrementally lower liquidity from the Fed. If investors accept this framework, it is readily seen that given the host of uncertainties that still exist and keeping its medium term objective in mind, the RBI has to keep policy rates at least this tight for longer irrespective of near term fall in inflation prints. Also, depending upon how these uncertainties pan out, at this juncture the chances of the next move being a hike are at least equal to those of it being a cut.
 
The above assessment is not necessarily negative news for bond investors. All it means is that, just like over the past 4 years, duration needs active management since the play remains capturing seasonal triggers in interest rates; while a structural call on rates will have to wait till the ongoing macro uncertainties align themselves to be consistent with the RBI’s medium term framework outcomes. This is exactly the philosophy reflected in our bond and gilt funds.
 
Disclaimer:
 
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
 
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency and should not be treated as endorsement of the views or as an investment advice. The information/recommendation provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The decision of the Investment Manager may not always be profitable, as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends.This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. This update has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. Neither the IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.

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