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Investment Insights

Suyash Choudhary

Market is aflutter since Rajan unveiled his intention not to continue beyond September as Governor of RBI. The timing, as well as the method of announcement, comes as a surprise to most participants insofar that perhaps there is a suggestion of less than full co-ordination and agreement between various policymakers. The letter seems to suggest that Rajan was amenable for a renewal but ‘on due reflection, and after consultation with the government’, decided to move on nevertheless. This in turn has naturally given rise to speculation whether the government would want a conduct of looser policy from the next Governor.

We analyze below this development in greater detail.

Timing

The timing of this transition is definitely less than desirable. There are near term headwinds to global risk-taking (Brexit vote this week) as well as to rupee in particular (Iran payments over 3 months and FCNR redemption between September – November). It must be remembered that currency fluctuation accounts for a large part of bond market decision making for offshore investors. The current mix of RBI and government policies have been deemed prudent by investors and has helped make the rupee a ‘low beta’ play amongst most emerging markets (EMs). This has improved the attractiveness of Indian financial assets to offshore investors, most particularly bond investors. The current transition perhaps makes the rupee on the margin more susceptible to episodes of global risk off. Thus if Britain’s vote and other episodic triggers create tailwinds to global risk- taking, then the transition may be looked at benignly. However if risk off were to take hold again then India may require compensatory tailwinds of its own (GST, growth green-shoots, other policy measures) to preserve the low beta status of the rupee.

Potential reaction function of the new Governor

A large part of the current criticism of Rajan seems to rest on the argument that he has kept rates too high while focusing on CPI, which rates cannot influence anyway. A vital point that gets forgotten in this argument is that it is the government that has given a signed mandate to the RBI to pursue a 4+/-2% target on CPI. Also this mandate has contributed significantly in preserving rupee as a low beta EM currency and attracting foreign capital flows. So if the government of the day did not want ‘high interest rates’ then it could have easily have set a different mandate for the RBI. Interest rates would then have been lower. However, the volatility associated with Indian assets would correspondingly have been higher as well. Arguments around CPI being a faulty target generally conveniently focus only on the merits of lower rates locally without bothering to acknowledge the benign rub-offs that CPI targeting has had on the flow of global risk capital into India; particularly in fixed income.

However, the immediate point about bringing to light the CPI targeting mandate is to also examine how a new Governor with (presumably) a more dovish disposition may be able to bring policy rates materially lower. In our view it can happen as follows:

a. A more liberal interpretation of the 4+/-2% target: Under the current regime, the RBI is focusing on 5% CPI by March 2017 and then 4% a year later (although the latter has looked like wishful thinking for some time now). Focusing on the mid-point of the band makes the target band longer term sustainable by purchasing some buffers against episodic inflation. However, the new Governor could focus only on the upper band and hence find room to cut rates further. He/she could also potentially focus more on ‘opportunistic windows’ for cutting, giving weight more to cyclical or episodic factors rather than structural themes.
b. A re-work of the CPI target: There are enough influential voices in current policy circles who argue for a re-work of the mandate, and include other measures like WPI and / or put greater weight to growth. This would then throw up a whole new paradigm for potential future policy reaction functions. However, it would be extremely negative messaging for offshore investors who will most likely take this as moving back in policy evolution.

Either way if a new Governor is perceived to be diluting the current CPI targeting regime, it is likely that offshore bond investors will start to look at India in a more tactical fashion than is the case currently.

Investor Takeaways

The announcement of this transition at RBI, on the margin, challenges the hitherto underlying paradigm of Indian bonds; that of low price volatility. This has especially been true since RBI unveiled the new liquidity stance in its April policy. However, more generally and especially in the eyes of offshore investors, Indian bonds have enjoyed the benign intersection of prudent RBI and government policies. If the RBI were to transition into a more ‘CPI tolerant’ central bank, then on the margin one pillar supporting lower volatility in both currency and bonds would weaken. This will get most visible during episodes of global risk-off, whereas periods of benign global risk will tend to mask this fact. Also, at some juncture local market participants may start to look forward to extra monetary easing that the new Governor may bring about. However, while we will try and be alive to this possibility, we think it is premature to already align to this view; for at least 3 reasons: One, the first full policy of the new Governor will come in the thick of FCNR outflows. It is hence likely that he/she waits out this period before deciding on further rate cuts. In this case the first real ‘window’ may then be towards calendar year end. Two, if average CPI continues to trend higher possibly on the back of the much anticipated post monsoon disinflation underwhelming and / or rupee starting to weaken meaningfully, then even incremental rate cuts may lose their potency to influence bond yields meaningfully and will in fact lead to further curve steepening. Three, if incremental easing is done largely through liquidity measures like CRR (a measure that the current Governor has resisted so far), this also would be a trigger for further curve steepening in which long duration will continue to underperform. Given all of this, we reiterate our view of 1 – 5 year rates offering the best risk-reward.

Of course it is equally possible that the government is well aware of the need to maintain continuity and that the new Governor doesn’t lead to any meaningful changes to the RBI’s reaction function. The new committee based approach to decision making may further cement continuity. In such an event, there may be no reason to revisit the current paradigm at all.

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Suyash Choudhary

The RBI kept all rates on hold as was expected by almost everyone in the market. However there were still a few notable takeaways, including from the policy statement as well as from the press conference afterwards, which are summarized below:
1. The April CPI reading of 5.39% seems to have caught the RBI by surprise because of the ‘more-than-seasonal jump in food prices’. The rise is broad-based across vegetables, fruits, sugar, meat and fish as well as in edible oils, spices, and non-alcoholic beverages. Recent declines in pulses inflation has also reversed. Core inflation has also been sticky around 5% with clothing and footwear registering moderate increases and services inflation remaining elevated. Three-months-ahead inflation expectations of households have also moved up marginally in May.

2. Given this inflation surprise, the future trajectory is also ‘somewhat more uncertain’. On the positives, monsoon, supply side responses, and the introduction of national agriculture market portal should moderate ‘unanticipated flares of food inflation’. Also industrial capacity utilization and hence pricing power is still modest. However, firming international commodity prices, Pay Commission implementation, recent upturn in inflationary expectations of households and corporate, and stickiness in core inflation can impart upside risks. All told, the central bank now assess an upside bias to its CPI projection given in the April policy.

3. The new liquidity stance of bringing long term deficit to zero has been reaffirmed. However, the Governor is unwilling to commit to an indicative calculation that he had provided in the April policy, where he had indicated taking around 8 months to take liquidity to zero. Instead there are softer indications that this will be done over a period of time and that the RBI will be ‘opportunistic’.

4. On the upcoming FCNR redemption, the Governor seemed to give a sense that around USD 20 billion should leave the country. The RBI is fully prepared in terms of providing both rupee and dollar liquidity. However 2 points were made that are of interest: One, as far as possible, the Governor wants the commercial banks to deliver on their forward dollar commitments to RBI and not get lulled into a sense of complacency that RBI will always give the residual dollars. Two, with respect to rupee liquidity, he seemed to indicate that short term liquidity will be provided in line with the liquidity stance.

Takeaways

1. We have been suggesting for some time that this could be a year of some sort of ‘inflection’ insofar that incremental sources of disinflation may not be readily forthcoming (please see “Of Monetary Easing, Inflection Points; and Investor Takeaways”, dated 22nd April 2016). The current policy seems to us to be the first test for the RBI on how to manage this inflection. Thus while there are upside risks cited to its primary policy target (CPI), there is a reaffirmation of its accommodative monetary policy stance. On the face of it, this is difficult to reconcile. However, the underlying motive is most likely reluctance to ‘rock the boat’ in any fashion till there are conclusive signs that a change in stance may be warranted. On a more generic level, this also tells towards the almost total lack of ‘disinflationary buffers’ in our current CPI dynamic.  Unless fresh disinflationary triggers are forthcoming, it is likely that the RBI will have to drop the explicit reference to accommodative stance in the months ahead. Our view remains that the rate cut cycle is broadly done.

2. It is not necessary that RBI will again resort to ‘high frequency’ OMOs around the period of FCNR redemption. This may be true for at least 2 reasons: One, they have already up-fronted a lot of the liquidity infusion via INR 70,000 crores of OMO (around 40% of total required by our calculation; please see “Free Lunches and Liquidity: A Bond and Macro Update, dated 3rd June 2016 for details) over the past 2 months. So the pace over the next 10 months needs to be nowhere as frantic.  Two, the Governor mentioned today that RBI may provide short term rupee liquidity as well at the time of FCNR outflow.

Given all of the above, we expect that the broad trend of curve steepening in place since October 2015 is likely to continue. Hence, we reaffirm our view that the best risk – reward remains in the 1 – 5 year maturities rather than in long duration.

 

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

It is now almost 2 months since the RBI flipped its liquidity stance committing to ‘lower the average ex ante liquidity deficit in the system from one percent of NDTL to a position closer to neutrality’. At the time the Governor had assessed the monthly run rate required of reserve money creation at around INR 25,000 crores. This translated into an annual requirement of INR 3,00,000 crores.

 

Core Liquidity Set to Improve Sharply…

 

The RBI has started executing the new framework with reasonable gusto, as evidenced by the INR 70,000 crores OMOs that it has already done over April and May. Coincidentally, this exactly neutralizes the currency leakage that has happened over the past two months. Owing to this and the government spending its balance with RBI, system liquidity deficit has shrunk to around INR 50,000 crores. Between June and August around INR 35,000 crores comes back into the system from draw down in currency in circulation. Also RBI will pay dividend to government in August of around INR 70,000 crores. It may also supplement this with some further OMOs during the period. All told, it is quite likely that the core liquidity in the system (defined here as total system liquidity adjusted for government cash balances) will head towards INR 1,00,000 crore surplus by end August. RBI’s forward dollar maturities ahead of FCNR outflow may help this surplus, but this will be temporary till the FCNR outflows happen.

 

…And Then Vanish

 

Between September and December, another INR 90,000 crores will leak out of the system in the form of rise in currency in circulation. Over and above, there may be a net dollar shortage in the system around FCNR which the RBI may be forced to plug via dollar sales to the market with consequence impact on rupee liquidity as well. It is difficult to estimate this impact at this juncture, but basis market expectation one can work with a number of USD 10 billion; translating into an INR 67,000 crore liquidity impact. The combined effect of these 2 forces will likely send core liquidity back into deficit mode. However, this would get tempered by incremental reserve money creation (OMO and forex) as well.

 

OMO Pace May Slacken Ahead…

 

The RBI has done INR 70,000 crores of OMO purchases over the first 2 months of the new financial year. Considering our liquidity expectation above, we would expect this pace to slacken in the period from now till the phase of actual FCNR outflows. It may then pick up again over the second half of the fiscal year, depending upon the situation with respect to forex flows. Importantly, however, it is quite likely that the RBI has already done around 40% of the year’s total OMO in the first 2 months of the fiscal itself. This number is basis an assumption that the RBI will do at least around USD 10 billion of net dollar purchase over the course of the financial year. A larger flow will entail lower OMOs and vice-versa.

 

…Thereby Re-exerting Bond Supply Pressures

 

Between February and May, net government bond supply to the market has been deeply negative owing to aggressive OMOs done over a short period of time; which may not be the case ahead. Further, the year’s supply of SDL and UDAY bonds is only just beginning. While UDAY supply will largely be under the ‘asset swap’ with banks, there is potentially INR 3,00,000 crores of SDL that will come over the next 10 months. By contrast, the so called investor segment (long end plus SDL) has been virtually starved over the past 2 months on lack of relative supply.

 

Macro Environment Less Supportive of Duration

 

The OMO ‘free lunch’ may have lulled the market into a sense of sanguinity just when macro dynamics may be at the cusp of at least a small inflection point. We have talked about this for some time (please see “Of Monetary Easing, Inflection Points; and Investor Takeaways’, dated 22nd April for details). The bulk of incremental disinflation in play over the past 2 years was on account of the following 4 factors: Lower MSP setting, efficient management of cereal stocks by government, collapse in rural wages, and fall in global commodities. While the first 2 are still in play, they are not providing incremental disinflation. Whereas, the last 2 are actually either contributing to incremental inflation or will do so in the time ahead. A further contributor could be the stronger urban demand on account of Pay Commission implementation over the next quarter.

 

Investor Takeaways

 

Since October 2015 the RBI has cut rates by 25 bps and done OMO buy back of around INR 1,50,000 crores. The 15 year government bond yield is actually up 10 bps from its low point in October, whereas the 4 year yield is down 25 bps over this period. We think this underlying trend of curve steepening is very logical towards end of rate cut cycles, and should start reasserting itself in the months ahead as most of the market frenzy around OMOs begins to subside. Lack of incremental disinflation will curb appetite for duration bonds whereas RBI’s new liquidity framework targeting system deficit should help front end rates. Accordingly, we continue to think that the best risk-reward for investor lies in 1 – 5 year segment of the curve via short term, intermediate bond and active duration strategies.

 

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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