By: Punam Sharma
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:
- 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.
- 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.
- 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.
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