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Investment Insights

Suyash Choudhary

Three Phases of Monetary Easing

 
Rate cuts are probably the most overt form of monetary easing, but they are certainly not the only one. Broadly speaking, there are three tools with the central bank:  rates, forward guidance, and liquidity. Monetary easing in the current cycle began in early 2015 when the RBI first started cutting rates. However, the initial bout of easing was accompanied with tentative guidance with the central bank presumably still assessing the pace of disinflation ahead. Around mid-year, the guidance evolved to being unequivocally dovish. Thus the second tool of forward guidance started getting deployed to directionally reaffirm the rate cuts. Finally, and after a good bit of lag, the RBI unveiled the third tool of liquidity in the April 2016 policy review; where it explicitly committed to take sustainable liquidity deficit to neutral from its hitherto ‘target’ of 1% deficit on NDTL.

 

There is a case to be made, and probably with benefit of hindsight, that the three phases could have run in better congruence than they actually did. Thus for instance, market feedback with respect to RBI’s liquidity stance has been forthcoming for some months now. And yet, till very recently the RBI’s push back was that they were controlling the weighted average call rate at levels close to the policy rate and in that sense there wasn’t necessarily any problem with system liquidity. Recognizing this is important for two reasons: One, the lag between rate cuts and transmission could have been compressed somewhat had RBI changed its liquidity stance earlier (for instance in September 2015 when it explicitly signaled its intent to pursue better transmission of rates from thereon).  Two, and this is important for the future, the shift now has locked RBI into committed effective monetary easing for the year ahead (better liquidity translating into lower rates is still monetary easing) when it may be argued that we may be approaching at least a minor inflection point with respect to growth and inflation.

 

A Possible Inflection Point

 

We have talked about the underlying global macro construct a lot since last year. To briefly recap, the global monetary and fiscal response to the 2008 global financial crisis triggered a new wave of gross capital misallocation most obviously represented by commodity investments made via US dollar leverage. The two pillars underlying this trade were: One, continued US dollar weakening amidst zero bound interest rates and quantitative easing, making dollar loans cheaper. Two, renewed commodity demand led by Chinese stimulus lulling companies into making longer term capacity creation investments. This trend started peaking by 2011 – 12 when dollar index bottomed and Chinese producer price inflation peaked. However, the trend on leverage creation overshot this turning point and only started to unwind when the reversal gained momentum by 2013 – 14. 2014 – 2015 were years of a spectacular manifestation of this unwind when the dollar index started to soar and commodities collapsed to the floor. World-wide disinflation got a massive tailwind as a result and India was no exception.

 

The point of the above summary is to indicate that these are long period cycle reversals and by no means can be deemed to have played out. Thus the global leverage overhang sustains even now and investment demand across the world is expected to remain weak. These will keep a lid both on commodity prices as well as prospects for global growth for a long time to come. However, there are two underlying points here of vital importance: One, the broad underlying construct described above was true even when oil was at USD 100 per barrel in early 2014. There probably wasn’t a sudden accelerated manifestation of the trend that took oil to USD 30. Similarly, if oil were to rise to, say, USD 60 (already at USD 45) over the next few months, that price move can still be accommodated within the same underlying framework. Thus while the broader framework of lower growth and commodity prices remains intact, there is every likelihood that there may no longer be any incremental disinflation coming from this quarter. Two, and this relates to the first point, one can (and does) get counter-trend moves within an overall longer term macro-construct. There is at least an even chance that we are witnessing something of the sort right now. 2015 was about an accelerated manifestation of the underlying capital misallocation cycle that potentially caught policy makers unawares. What we may be witnessing now is a short term backstop getting created. There are at least three reasons that indicate why this may be the case:

 
1. US dollar strength seems to have broadly played out for now on the back of some pull back in economic data and with the Fed talking down the dollar. This, on the margin, has eased a big pressure point for global leverage; at least in the short term.
2. China has turned up policy stimulus as being shown directly in their aggregate financing data as well as the resurgent trend in property prices.
3. US oil production is finally declining noticeably after almost two consecutive years of investment cut backs.

 

These are helping create at least a temporary tailwind to commodity prices with the result that metals, oil, iron ore etc have rallied sharply over the past few months.

 

The Indian Context

 

From India’s standpoint as well, and that is really the point of the discussion above, it is worth examining whether we are at an inflection point of sorts. There are again at least three reasons why we think this may be the case:

 

1. As discussed above the global disinflationary impulse seems to be behind us for now. Barring fresh developments and basis recent policy actions as explained above, it is unreasonable to assume that fresh global disinflationary impulses will support our CPI fall, as they have been doing for the past two years. Indeed, apart from oil and metals, other commodities like sugar and edible oils have also been going up lately; although obviously for different reasons.

 
2. Rural wages seem to be bottoming out given government’s renewed commitment towards increasing farm incomes and prospects of a better monsoon ahead. Furthermore, urban consumption looks set to also receive a shot in the arm as the central government is slated to implement the Pay Commission recommendations in the next few months. It is to be noted that this will get followed up by states as well as public sector enterprises selectively implementing their own pay hikes as well. Thus all told consumption (rural plus urban) seems set to rebound over the next few quarters. This will naturally raise demand, and in the absence of equivalent supply responses, may risk fuelling some incremental price rise. In this context it must be mentioned that an excessive reliance on monsoon as the trigger for monetary easing risks trivializing the framework of long-term CPI targeting.

 
3. Finally, RBI policy is also unlikely to contribute towards incremental disinflation going forward. This is because the central bank is now ‘locked’ into a forward commitment to the market to progressively reduce system liquidity deficit to neutral over the course of the next year or so. This means that one can continue to look forward to a grind down in front end rates or, put another way, de-facto further monetary easing over the next few months.
 

Investor Takeaways

 

We have preferred to align to a curve steepening view since December of last year (for details please refer to “The Opportunity Set Shifts: A Bond Strategy Update”, dated 22nd December 2015). This trade has been temporarily disrupted since mid-March, largely as pointed RBI OMOs took away a large part of market position within a span of three weeks. However, we think that as we move deeper into the new auction supply calendar, the curve steepening trend will resume. Over and above this, if our assessment presented above proves to be true, market will be faced with two conflicting forces over the next few months: One, as conviction with respect to future sources of disinflation wanes the appetite for long duration will naturally start to get impacted. Two, overnight rates will start setting at or below policy rates consistently versus the earlier regime. This will exert a natural pull to front end rates and improve visibility of roll down available. These forces cumulatively will further help the steepening trade, in our view. Basis this we think investors should continue to align towards front end rates (1 to 5 yrs) through short and medium term products and / or through active managed bond products.

 

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 about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions 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 recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the stocks may or may not continue to form part of the scheme’s portfolio in future. 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. Neither 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 cut repo rate by 25 bps as was widely expected. Simultaneously, market was also expecting steps on liquidity. This expectation has been rewarded as well, potentially by more than most would have expected. Thus the RBI has done the following on liquidity:

 

1. Reduced daily CRR requirement for banks from 95% of net demand and time liabilities (NDTL) to 90% of NDTL while keeping CRR unchanged at 4%.
 
2. Committed to progressively reduce liquidity deficit in system from 1% of NDTL to ‘a position closer to neutrality’.
 
3. Narrow the policy corridor from +/- 100 bps to +/- 50 bps by reducing MSF rate by 75 bps and increasing reverse repo rate by 25 bps.

 

RBI’s assessment of global growth is still muted and it also perceives a risk that the uneasy calm in global markets since the January sell off can be dispelled by a sudden risk off on incoming data. The domestic growth assessment is much more sanguine. On CPI inflation, the RBI seems to have a comfortable view on food and fuel. However, core CPI seems to be resistant at 5% owing to capacity constraints in the services sector. This has upside risks from 7th Pay Commission and OROP as also from increase in service tax rates. On the flip side, rural wage growth as well as growth in corporate staff costs are moderate. Also, input and output prices for PMI manufacturing and services have risen only modestly. Overall, CPI is expected to remain around 5% during FY 17 with uncertainties emanating from recent unseasonal rains, monsoons, low reservoir levels, and strength of recent upturn in commodities. Offsets to these risks may come from tepid global demand, government’s supply management of food, and the centre’s fiscal consolidation.

 

The stance of policy is still kept ‘accommodative’ with the RBI committing to ‘continue to watch macroeconomic and financial developments in the months ahead with a view to responding with further policy action as space opens up. At the same time there is a clear message that the focus of policy is to ensure that current and past policy rate cuts transmit to lending rates. It is really to further this effort that the liquidity paradigm has been shifted by the central bank. The anchor to this paradigm shift is the statement ‘experience suggests that the provision of short term liquidity does not substitute fully for needed durable liquidity, though durable liquidity can substitute for short term liquidity needs’.
 
Assessment and Takeaways:
 

Our fixed income stance since December has been guided by 3 underlying principles. It is in the context of this framework that we assess below today’s policy:

 

1. Prospect of crowding out owing to heavy bond supply: The RBI today has shown a decided preference for creation of permanent liquidity to the extent required over other shorter term sources of liquidity infusion. Importantly, the mandate to take liquidity to neutral won’t get executed right-away but will get spread over the rest of the financial year. Including the natural leakage that happens during the year and accounting for the fact that we are already starting from a deficit, the Governor assessed that monthly run-rate of reserve money creation needs to be around INR 25,000 crores. This translates into an annual requirement of INR 3,00,000 crores. Adjusting for RBI dividend to government and normal forex accretion (our basic balance is increasingly turning more positive and barring an aggressive reversal in capital flow, one would still assess net forex accretion), this probably translates into one OMO of INR 15,000 crores a month. This could turn out to be lower if capital flows are more supportive (either speculative FPI capital or that emanating from government measures to attract infrastructure funding). In our base case, we would have anyway assigned OMOs of at least INR 1,00,000 crores in the year ahead.
 

Furthermore, the earlier envisaged supply of UDAY bonds has now started hitting the market. All told, as per media reports, against INR 2,00,000 crores of loans getting covered under UDAY, INR 1,00,000 crores of UDAY bonds have already been created. Another INR 1,50,000 – 2,00,000 crores of UDAY bonds are potentially due over FY17. Importantly, banks have been granted HTM for these bonds. However, unlike in the normal HTM, there is no cap on how much banks can transfer out and sell from the UDAY HTM. Also these bonds are also being issued to other investors directly as well as to the open market via RBI. This means that supply of these bonds to the market will virtually be continuous in the time ahead. Finally, banks’ HTM rationalization of 0.25% NDTL a quarter will continue into the new financial year.

 
2. Weaker forward interest rate expectation: In our assessment this was most likely the last rate cut in the current cycle. As we have assessed before, cyclical disinflation seems to have peaked out and further gains from here will have to depend upon structural measures. Another avenue for rate cuts could have potentially arisen from a leg down in growth. This looks unlikely at this juncture given the likely consumption boost ahead (from Pay Commission and upturn in rural wages). Furthermore, there are clear upside risks to CPI as assessed by the RBI itself. It is to be noted that the upside risk factors are clearly defined whereas the compensatory factors are more generic like global demand and fiscal consolidation. Given these, for all practical purposes, market may move ahead with minimal further rate cut expectation.
 
3. Steepness at the front end of the curve: January and February were about bear steepening of the yield curve. March was a hiatus where, owing to concentrated OMOs from RBI amounting to INR 42,000 crores in a matter of days, the curve bull flattened. However, now that that phase has passed, the curve has resumed steepening; this time in a bull fashion. We expect this theme to continue over most of the rest of the year as well. Indeed, if liquidity were to move towards neutral, shorter end rates will rally meaningfully from here. The main risk to this view is that if CPI undershoots against our expectation and that leads to market building back rate cut expectations.
 

Conclusion
 
It is logical to expect steeper curves towards the end of a rate cycle. While RBI’s additional OMOs (over our expectation) may slow the trend, we don’t think the trend gets upset entirely. Our advise to investors is this: market volatility has picked up meaningfully, as exhibited in the months of February and March where yields first rose sharply and then fell sharply. Thus it is even less fruitful than usual to make investing decisions based on recent past returns. Instead investors should align to an underlying theme and allocate accordingly.

 

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 about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions 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 recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the stocks may or may not continue to form part of the scheme’s portfolio in future. 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. Neither 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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