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Investment Insights

Suyash Choudhary

With CPI inflation undershooting consensus expectations and a sharp fall in crude prices providing a windfall, market expectations of an early rate cut from the RBI seem to have gone up over the past few days. The recent sharp fall in 1 year swap rates is to a large part technical, with market position shuffling playing a significant part. However, it also reflects this very expectation of an early rate cut. Comments recently by the finance minister (desiring lower rates but, quite credibly, leaving the decision to the RBI) as well as by a key RBI advisor (flagging possibility of a March rate cut) have further fuelled these expectations. Our purpose here is not to speculate whether these expectations are right or wrong. The simple reason why we won’t speculate is that it doesn’t matter to our portfolio strategies or our client recommendations as to what the timing is. All that matters to us is that the next move, whenever it is, is a cut. What matters also is that the direction of CPI inflation remains lower, and with some amount of sustainability. At this juncture, we have strong confidence that both these conditions are going to get met.

 

The purpose of this note, rather, is to provide some filters and consequent action points to investors that we think are very relevant to the current macro-economic and macro- set up. We have been making these points for some time now but it doesn’t hurt to restate:

 

  1. RBI’s monetary policy reaction function has gone a regime change with the Urjit Patel Committee Report of January 2014. The focus is almost entirely on ensuring a durable fall in CPI inflation to the 6% mark. This focus was much required since, apart from deterioration in capital productivity, persistently high CPI inflation was the single major variable responsible for India’s macro-economic imbalances; in our view. Governor Rajan has made this point time and again that he wants to fight the inflation battle once and not repeatedly. This means that he needs to be very sure that his inflation targets are getting met even accounting  for cyclical vagaries that India witnesses (erratic monsoons). Even more, he needs to account for the possible reduction in disinflationary momentum purely by the fact of monetary easing and still be sure that the inflation targets are not under threat. These imply that either there needs to be a ‘buffer’ that RBI will ensure for its 6% target, or the comfort with respect to government policies and / or the pace of disinflation needs to be high enough to be sure that cyclical vagaries will not cause durable deviations from the target. What is also important to note is, just as before, the central bank will be willing to look through short term disruptions as long as medium term targets are not under threat.
  2. Investors should not consider a rate cut as an event that one has to play for. A one off 25 bps cut will not have much significance either for financial markets or the real economy, unless it is backed by confidence that more are to follow . Again Rajan has made it abundantly clear that he doesn’t want to start the cuts only to reverse them later. This is as it should be, given India’s own recent history with premature cuts that helped inflict significant damage later and had to be reversed. Therefore, we think Rajan’s first rate cut will only happen when the pre-conditions mentioned in point 1 above are met. Furthermore, it will signal RBI’s comfort with shifting the monetary stance durably without fear of reversal and will hence also signal the central bank’s assessment that the ‘bullet-proofing’ of India’s balance sheet is significantly achieved.
  3. On the flip side of bullish rate cut expectations is the fear that RBI has to be slave to US Fed rate hikes. Thus some section of investors believe that the RBI cannot cut rates at least unless the Fed hikes its own rate. In our view, this fear is misguided simply because again the underlying premise is that the Fed rate hike is an event rather than a process. True the timing of the first Fed rate hike matters. But what matters almost equally is the pace of rate hikes subsequently as well as market’s expectation of what the terminal Fed rate is going to look like. Purely as an observer, it looks highly unlikely to us that the Fed can embark upon a sustained rate hike cycle of its own even as big question marks simultaneously emerge on growth in every other large economy including the Eurozone, China, and Japan. Investors must also remember that in the last Fed rate hike cycle that started in 2004, 10 year bond yields actually fell since the market had presumably overpriced the impact of the hikes. In summary then, if the RBI is confident of its own macro-economic situation (mainly inflation) then it will not wait for the Fed to act given that the full impact of the entire Fed rate cycle may take years to unfold.

 

Investors should remember, and this is a point that we have made repeatedly over the past few months, that the fundamental reason to own bonds is falling inflation. So long as there is relative certainty that India is heading towards a regime of low and stable inflation (and for a host of reasons that we have mentioned elsewhere we do), the current yields available in the market are too good to pass. The argument can be positioned in terms of positive ‘real yields’ that Indian bonds are offering for the first time in many years. Alternatively, more ‘market minded’ investors may think of this as an environment where term spreads will continue to compress as market’s inflation expectations continue falling and there comes about relative certainty that the next move whenever is a rate cut. This is exactly what has been happening over the past few months. Whichever way one looks at it, it is a good time for asset allocators to bond funds. Risk appetite and investment horizon should determine the choice of bond product; or the relative allocation to conservative versus aggressive bond products. However, the thought process driving the allocation has to be fundamental and not tactical. Falling inflation and not near term rate cut gratification is the trigger. Most importantly, we would argue this to be the right trigger to ensure durability of returns as opposed to the flashes in the pan that investors have been used to seeing over the past few years.

 

 

 

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

It is by now apparent to even the most hopeful in the bond market that the RBI is in no hurry to cut the repo rate. This has been brought home in no uncertain terms by the RBI Governor since the August policy review. On our part, we have never harbored any such illusions and have been quite clear ever since the Urjit Patel Committee report of January 2014 that the central bank intends to see through its inflation glide-path that targets CPI inflation at 6% by January 2016. And needless to add, the fall has to be durable so that there is reasonable confidence that the target is not only met but also gets sustained. It is largely for this reason that we weren’t very sanguine on long duration in the run up to the general elections; since if the verdict had thrown undesirable outcomes for government macro-economic policy then the RBI would have unhesitatingly stepped in to shoulder the burden to ensure that its inflation goals were met. This would have most likely meant more rate hikes still. However, as it has turned out, the new government has come in with a strong mandate and complementary policies. This has allowed RBI to take a back seat and adopt a neutral stance on rates, although it remains vigilant on two-way risks to inflation. Hence chances of a rate hike have receded, though as mentioned before, we think a rate cut is also a long time away.
 
With this policy neutrality in mind and overlaying our assessment of government policies as well as evolving CPI trajectory, we have gone long on duration in our bond funds over the past few months. Very importantly, and this point has been underscored in almost all our communications, our trigger to do so isn’t expectation of near term rate cuts from the RBI. Rather, the reason is much more fundamental: that for the first time in years there is significant policy credibility (both from RBI and government) to achieve durable low and stable inflation. Put another way, there is almost an insistence from policy makers to ensure that savers make real positive returns on their fixed income investments. This to us is the most powerful incentive to make allocations to financial instruments including to bond funds.
 
Our reasons notwithstanding, some investors may still argue that if there are no rate cuts in the near term then there is no hurry to invest as well; since bond yields won’t fall till RBI starts cutting rates. The purpose of this note is to answer this question: are rate cuts necessary for bond yields to fall? The short answer to us is no: bond yields can change even with no change in repo rate as the market keeps adjusting the ‘term premium’ (defined here most simply as the difference between yield of 10 year government bond and the repo rate) that it demands for holding long maturity bonds. This has been visible over the past few months as well where 10 year bond yield has fallen by 50 bps without RBI making any changes to the repo rate. Below we have listed three of the biggest reasons why we think term premium can shrink further over the coming months:
 
1. Rising confidence with respect to future trajectory of inflation: Momentum on ‘trimmed inflation’ (excluding volatile items) has been falling for the past few months now, aided by fall in rural wage growth, lower minimum support price (MSP) settings and recent weakening of housing and fuel inflation. Price fluctuations in even the more volatile food basket have been more transitory owing to pro-active measures from the government to curb vegetable and cereal prices. Recent fall in global commodity prices in context of relative rupee stability has lent even more confidence to the inflation outlook. All told, both RBI and the market are now more confident of a falling inflation trajectory than they were even a few months ago. We believe it is quite likely that this confidence increases further in the months ahead. As this happens and market begins to price in a greater certainty that the next move from the RBI will definitely be a cut, the term premium on the yield curve can shrink further.
 
2. Banks’ muted credit growth and improving credit to deposit ratio: Despite improvement in sentiment over the past few months, actual credit growth continues to languish. Year on year credit growth rate of sub 10% currently is at a multi year low. However, this number comes off a very high base from last year when a freeze in money markets had caused a jump in recourse to bank lines. A better way to look at the data is as presented in the chart below:
 

 
Source: RBI and IDFC MF Research
 
As can be seen from the chart, total non food credit growth year to date so far is amongst the slowest in the last five years. Also, as the next chart shows this has driven a substantial positive wedge between deposit growth and credit growth.
 

 
Source: RBI and IDFC MF Research
 
To be sure, and as recently noted by RBI, some part of the credit slowdown merely represents a diversification of funding source to non bank means. Irrespective, this implies lower off-take for banks. The fact that leading banks have cut deposit rates recently, in the run up to the start of the ‘busy’ season of credit would indicate that there is limited expectation of any near term pick up in credit off-take. This phenomenon should keep banks’ appetite for bonds robust and provides another reason for eventual further fall in term premium.
 
3. Net supply of government bonds: The third major reason, in our view, for expecting a further fall in term premium over the next few months has to do with the supply calendar for government bonds.
 

 
Source: RBI and IDFC MF Research
 
The supply calendar for October – March is much better distributed than in previous years. As can be seen from the chart, effective net supply (adjusted for maturities and RBI’s OMOs) in October- December this year is comparable to FY 13 and much lower than in FY14 (we have assumed that RBI will be selling INR 5,000 crores of bonds to the market every month, in line with recent trend). Supply picks up in January but this coincides well with the fact that investor demand (insurance and PF) typically also picks up in the last quarter. Given this much smoother distribution of supply, it is likely that market participants settle for lesser term premium when bidding for auctions, all other things remaining the same.
 
Conclusion:
 
A credible institutional framework to anchor inflation combined with recent favorable trends has created much greater confidence in expecting sustained lower inflation in the years ahead. This, and the positive real yield on investment that it entails, provides the most basic reason for savers to be buying fixed income instruments. Bond fund investors waiting for signs of rate cuts from RBI should remember that yields can continue to fall even in the absence of rate cuts for the reasons described above. Instead, and armed with the fundamental reason as mentioned here, it is best to avoid being ‘thematic’ and / or ‘tactical’ with investments and not delay appropriate asset allocation in line with individual investment horizons.
 
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 on hold as expected. Other changes made were as follows:
 
1. Reduced liquidity provided under export credit refinance (ECR) facility further from 32% of eligible export credit to 15%.
 
2. Allowed banks to include another 5% of net demand and time liabilities (NDTL) within the mandatory statutory liquidity ratio (SLR) requirement to qualify under eligible level 1 asset to meet the liquidity coverage ratio (LCR) requirements due from next year.
 
3. Provided roadmap to bring down held to maturity (HTM) ceiling on SLR securities from 24% of NDTL currently to 22% of NDTL in a graduated manner: 50 bps every quarter starting January 2015.
 
Assessment
 
Market had gone into the policy somewhat cautious on two counts: One, whether higher than expected HTM cut can dent banks’ appetite for government bonds. Two, whether RBI further qualifies its inflation goals by referring to some explicit ‘real’ rate targets in a way that could potentially change market’s expectation of policy rate trajectory going ahead. That is, whether reference to real rate targets can potentially upset market’s bullish view on interest rates despite falling inflation ahead. However, on both counts the RBI has assuaged market fears. By giving a calibrated road map for HTM cuts the central bank has ensured that there is no dent to near term appetite for bonds. HTM cuts have been timed closely with reducing supply (as future fiscal deficit targets fall further) and potential other sources of demand (presumably calibrated enhancements in FII participation in domestic bonds will continue going forward). On the point about inflation and real rates, despite persistent prodding by media the RBI governor has refrained from specifying any real rate target instead saying that he will be looking at other developments like credit and deposit growth, demand for financial assets, etc to also gauge what level of real rate is appropriate. On the inflation goal itself, developments have been positive since the last policy and these have been acknowledged by the central bank. Furthermore, while its own model forecast suggests CPI will still be at 7% by Q4 FY 16, the governor has been quick to qualify that if they overlay their qualitative assessment over the model projections, then there is far greater likelihood of achieving the 6% target by January 2016.
 
Takeaways and View Forward
 
The RBI is, and has been since January 2014, fully committed to achieving its inflation targets. To reiterate, this means that it intends to ensure that CPI falls to 6% by January 2016 and does so in a durable fashion. For this reason, we expect that the central bank will continue to lag consensus market expectations of rate cuts. This is largely because its threshold for monetary easing will continue to be far higher than what the consensus of market will expect. However, what is also true, is that for the first time in many years there is now visibility that average CPI inflation over the next few years will be much lower than what it was in the past 5 years. Factors that are contributing to this visibility include lower minimum support price (MSP) setting for 2 years now, rationalization of government food procurement policies as well timely interventions to arrest food price spikes, visible deceleration in rural wage growth, a benign global commodity cycle, and stronger commitments to ongoing fiscal consolidation as well as real positive interest rate setting. As can be seen, most of these factors pertain to institutional credibility and visible action bias from both the government and the RBI to ensure a durable regime of lower inflation. As we have been highlighting for some time, this to us is the most fundamental reason to be buying bonds; NOT when the RBI will cut interest rates.
 
If investors were to look back, it is quite plain that RBI rate cuts have never delivered sustained bond returns over the past few years. The rate cuts in 2013 happened despite high CPI inflation and high current account deficit and hence had to be quickly reversed (Fed’s taper tantrum was only a proximate factor in our view that determined the speed of reversal rather than direction of policy). In contrast, today policy rates are high despite dramatically improving inflation and current account simply because the central bank wants to purchase durable stability once and for all. The strategy is all the more prudent given the flux that exists today in global monetary policies. Given this, we would expect that the term premium on the yield curve will compress further going forward as market gains more confidence as to the falling trajectory of CPI inflation. Another factor that may contribute to this phenomenon is that the government bond supply calendar for October- December is quite modest when compared to the last 2 years.
 
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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