Suyash Choudhary

The market is clamouring for rate cuts
 
The chorus demanding rate cuts from the RBI has grown stronger in the past couple of weeks with noted academicians and economists also lending their weight to the camp.
 
– Fresh impetus has been provided by signs that the GDP rebound seen in the first quarter was a false dawn and more concurrent indicators suggest a sluggish economy
 
– Additionally there appears to be a sustained fall in inflation
 
– The market has also been conditioned to the somewhat-tactical approach towards rate cuts that the RBI used to have.
 
Hence, it is plain to see the rationale behind the conventional case for a rate cut
 
Our push back against this conventional case for rate cuts (please refer ‘Rate Cut Won’t Be an Event But a Process’, dated 22nd October).
 
– We think it is quite likely that the RBI will LAG MARKET EXPECTATIONS since it will want to purchase reasonable certainty that its 6% CPI target is achievable.
 
– Additionally, it will not want to be tactical with rates preferring instead to SIGNAL A REGIME SHIFT WITH ITS FIRST RATE CUT.
 
 
DESPITE THIS STANCE, WE ARE VERY BULLISH ON BONDS
 
Our bullishness is on account of what we believe is a STRUCTURAL BREAK IN INDIA’S INFLATION TRAJECTORY, which is ensuring that we are enjoying ‘real positive’ interest rates for the first time in many years. As long as this is the case, we are not concerned about the timing of RBI’s rate cuts.
 
Why does our stance differ from the market even though both camps are bullish?
 
A justifiable question that investors may ask is this: ‘Why our continued caution on RBI policy when the end outcome in terms of portfolio strategy is the same – being long bonds?’ Put another way, ‘How does it matter whether our reason to buy bonds is falling inflation or RBI rate cut expectations; so long as we are buying bonds?’.
 
It matters because
 
– If investors continue to consider fixed income allocations tactically on the basis of near term rate cut expectations, they are likely to respond with alarm if these EXPECTATIONS DON’T RECEIVE IMMEDIATE GRATIFICATION.
 
Greed for near term gains causes many investors to over-allocate beyond their natural risk appetite which forces a course correction when expected outcome doesn’t materialize.
 
– If investors view this as a tactical opportunity and not a structural reset they may approach it as a trader would, and NOT CONSIDER THE LARGER RAMIFICATIONS that the environment may have for their overall fixed income portfolio.
 
So what is the larger macro-economic theme which is unfolding and how should investors orient their fixed income investment strategy?
 
THE SAVINGS – INVESTMENTS DISEQUILIBRIUM
 
The last few years have been a bear market on Indian interest rates simply because CPI inflation has been running in double digits and there has been a savings – investment disequilibrium in the economy.
 
Put simply, this means that demand for funds (for investments / consumption) had been running ahead of supply (from savings).
 
Hence, the role for interest rates has been more to incentivize savers than encourage consumers / investors. Whenever RBI has gone against this fundamental logic and cut rates (as it did last year despite a high current account deficit), it hasn’t been a sustained rate cycle.
 
For the first time in many years it appears that this disequilibrium between demand and supply of funds is correcting for India.
 
This fact is supported by the following indicators –
– The continued compression in our current account deficit (CAD)
– Banks have started cutting deposit rates just at the start of ‘busy’ season on credit. In fact, media reports suggest that many of the larger banks may start bringing down lending rates as well towards the last quarter of this financial year.
 
So what is driving this narrowing gap between demand & supply of funds?
 
1. REAL POSITIVE INTEREST RATES for the first time in many years will incentivize savers.
If indeed we are witnessing a structural break in inflation, then this incentive should continue in the years ahead.
 
Why do we think that average CPI inflation will be lower in the next few years?
o Lower minimum support price (MSP) settings for two years now
o Deceleration in rural wage growth,
o Rationalization in government’s grain procurement and off-loading policies
o Rethink in MNREGA structure allocations
 
2. SHIFTING SAVINGS TOWARDS BANKS – With some slowdown in rural wages and inflation, terms of trade may have started shifting away from the rural / unbanked economy. While this doesn’t change the quantum of available savings, it may on the margin help in increasing the share of bank deposits in the overall savings pool.
 
3. PERFORMANCE OF GOLD AND REAL ESTATE as asset classes has turned after a very strong run in recent years. Hence, there is further disincentive to park savings there.
 
4. FINANCIAL INCLUSION FOR INCREASED FINANCIAL SAVINGS – The new government is taking forward the ‘financial inclusion’ agenda via schemes like the ‘Jan Dhan Yojna’ which are effectively working towards extending the net for financial savings over time
 
5. A WELL BEHAVED CURRENT ACCOUNT DEFICIT – A possible turn in the global commodity ‘super-cycle’ , incremental de-bottlenecking of inputs’ supply and a potential pick up in initiatives like ‘Make In India’ all argue for a well behaved CAD (savings – investment imbalance) even as growth picks up in the years ahead.
 
Narrowing of the Savings – Investment disequilibrium = > Lower interest rates over time
 
So how should we think about fixed income investing in this new environment?
 
WHY FMPs MAY NOT BE SUCH A GREAT IDEA ANYMORE
 
Investors over the past many years have been used to thinking FMPs and money market funds when they think fixed income. This has largely worked since in a rising rate environment since –
 
– Lowest maturity product should do the best.
– No real fear of ‘reinvestment risk’.
 
Thus, every year maturing FMPs would always deliver a sufficiently attractive reinvestment option which was almost always as much or more than a short term or long term bond fund could consistently deliver.
 
Bond funds, in turn, were used tactically.
 
However, as the disequilibrium closes some of the ‘truisms’ that investors have been used to may not exist going ahead.
 
In case of a structural break in inflation, reinvestment risk becomes a real, tangible risk
 
Banks have already started cutting deposit rates as an early sign of the disequilibrium getting restored.
 
Should the process progress further, investors may no longer have the assurance of predictability of similar or higher rates when their FMP allocations come up for reinvestment.
 
I.e. the 8 or 9% on the FMP product we took for granted may not be available anymore
 
How to hedge for reinvestment risk?
 
Investors should start looking at bond funds as a means of hedging their future reinvestment risks. The choice of short, medium or long term would depend upon investment objectives and risk appetite
 
The new environment will likely remove the need to think about how to beat inflation –
 
One still sees commentary in various media where financial advisors discuss ways to beat inflation.
 
In an environment where long term interest rates are already giving almost 2% returns over inflation, the only way such discussions are still relevant is if investors are still not confident that inflation will indeed get anchored at the RBI’s target of 6% going forward.
 
It stands to reason then that AS INFLATION EXPECTATIONS REDUCE, more investors will find the value of long term asset allocation to fixed income.
 
The new normal for fixed income allocations –
 
Finally, and this is where the title of this note draws inspiration from, investors may still want to forecast future returns when deciding whether or not to make bond allocations. However, this is often a futile exercise fraught with a host of measuring risks.
 
What we are effectively arguing for here is to look at allocations in a different way.

– Don’t take the current level of interest rates for granted

– As conviction increases that the inflation regime has indeed shifted, these rates may not be available for future reinvestment

– Thereby increasing the importance of earning the current level of interest rates for longer periods of time

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