By: Punam Sharma
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.
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.
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