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Investment Insights

Suyash Choudhary

Urjit Patel Signs In
 
The appointment of Urjit Patel as the next RBI governor rounds off two months of hectic speculation in local financial markets. The consistent underlying theme of this speculation was that the government had just about had it with Rajan’s ‘tight’ monetary policy and now wanted to ‘give growth a chance’. A related line of thinking was that the 4+/-2% target on CPI may be diluted, either via expanding the band or mixing the target variable (CPI) with some bit of WPI. Indeed, some of the names doing the rounds for the new governor may have preferred such a dilution.
 
As it has turned out and much to its credit, the government has notified the 4+/-2% CPI target as the official mandate for monetary policy all the way till March 2021. Alongside it has appointed Patel, who was the chief architect of the CPI targeting framework of the RBI. With these, it has ensured as much of full continuity as is possible with a change of leadership. It has also laid to rest speculation that Rajan was standing in the way of its endeavor to re-inflate the economy.
 
From a market’s standpoint, some points are of relevance:
 
1. There is no reason to assume immediate hawkishness from the new governor. In its last communication the RBI, presumably inclusive of Patel, retained upside risks to its 5% target of 2017 but still kept the stance as accommodative. This stance in turn has two legs to it: One, the central bank will look for room to cut further; presumably if upside risks to CPI were to not materialize. Two, it will continue to execute its new liquidity framework of zero liquidity deficit. We fully expect this stance to get carried forward given that there is almost full continuity with the new governor. It is quite likely that with the disinflation ahead on pulses and vegetables, the upside risks seen today to CPI vanish and a final rate cut may get slipped in. Whereas, with liquidity surplus likely to vanish again over the months ahead, the RBI should resume OMOs. Hence, to reiterate, there is no reason to position for immediate hawkishness. The only caveat here is that if Patel leans also on CRR cuts as a method of liquidity infusion, which Rajan had avoided, then expectations of total OMOs for rest of year (currently around INR 1,00,000 – 1,20,000 crores more) will need to get scaled down. This may lead to some relative pressure on longer duration bonds and associated curve steepening.
 
2. At the same time the expectations of outlier aggressive easing, based on an entirely new macro-construct of a substantially different governor, will also need to be done away with. Urjit Patel is very much a believer in orthodox monetary and fiscal policy and will no doubt also be concerned about the medium term sustenance of the CPI targets. He will also calibrate liquidity creation with the inflation objectives of the RBI. These are very much along the lines of what Rajan may have done had he continued.
 
Given the above, and borrowing from a turn of phrase we heard in the market, it seems the most appropriate to position for an environment of ‘constrained bullishness’. Should no unanticipated new pressures emerge, the next few CPI readings will show a substantial collapse which, alongside RBI’s liquidity operations, should provide a reasonably conducive environment for yields. At the same time given almost full continuity at RBI and the underlying structure of our CPI (for details, please refer “Use Your Illusion: A Bond Market Update”, dated 16th August), one should fade the hopes of outlier aggressive easing. Given this, from a portfolio strategy and fund selection stand-point nuances like demand – supply, relative shape of the curve, and volatility versus participation trade-off will need to be kept in mind.
 
A Thought For The Saver
 
In this phase of speculation over the past two months, a lot of criticism has also been piled upon the existing monetary policy regime. The central argument seems to be this: Raising interest rates will not control the prices of potatoes and onions, whereas RBI has kept growth ‘hostage’ by not lowering rates. To the extent that this argument is cautioning the central bank that while it has taken on a CPI target its direct ability to control CPI is fairly limited and hence may cause credibly loss down the line, it appears valid. However, in our view, in almost all other aspects the argument seems woefully short of sound logic. Rajan himself has been vocally exposing the hollowness of these arguments via some excellent speeches lately. However, we cannot resist making some more points below.
 
India has only very recently emerged from a massive savings crisis in 2013. While through a mix of good policy and good fortune our current account deficit is now next to zero, it is quite amazing how still in many macro constructs and commentaries the role of interest rates in incentivizing savings is still almost absent. Even though we don’t have a savings crisis today, we are nevertheless not pursuing many developmental projects owing to lack of savings. Just as one example, our roads, railways and waterways combined can absorb lakhs of crores should that funding be available. While our financial savings to GDP ratio remains this anemic, surely interest rates have a major role to play in incentivizing savings so that our growth ambitions today don’t sow the seeds for the next savings crisis down the line? Looked at from this context, while interest rates may not be able to directly influence CPI, they can at least ensure that savers always get a positive compensation over whatever inflation there is. Overtime this may provide a strong incentive for incremental savings to flow into the financial system. Such a policy framework will also keep the currency stable and hence continue to attract global savings to us.
 
Instead, the general propensity seems to be to look at interest rates as a cost item only. Corporate credit is stagnant due to capital misallocation decisions taken in the years of loose money since the global financial crisis. The problem is not unique to India and is unlikely to resolve itself if interest rates were to fall another 100 bps. Now if It were a costless decision to make this 100 bps reduction, then it may have been worthwhile to give all the help possible to get incremental loans going. Unfortunately, it is not. Aggressive rate cuts in the face of sticky macro aggregates can jeopardize both domestic and international savings pools that are currently funding our investments/consumption. Even if the cost of borrowing is genuinely high for certain economic entities (for instance SMEs), it is on the back of hefty risk spreads currently being levied by lenders over and above the underlying sovereign rates. These risk spreads are again linked to the current bad loan mix in banks’ books which in turn is a result of the previous cycle of capital misallocation. As an aside, the cost of borrowing certainly doesn’t seem to be a constraint in loan growth of many banks in the private sector and in certain segments of lending, like consumer credit.
 
In our view, these perspectives are not merely for academic interest but may have real implications for bond investors. This is because the almost righteous view taking that constantly laments high interest rates may cause lazy, ‘perma-bull’ kind of biases that may fail to catch cycle turning points. It also leads one to make simplistic correlations between global and local situations. For instance, as compared with many other parts of the world, our inflation is much stickier, our combined fiscal deficit is much higher, and our avenues for long term productive deployment of capital are much stronger. In such a scenario, while some broad correlations will exist between our rates and those in other parts of the world, it is risky to draw direct conclusions with respect to the quantum of fall possible in our rates just because G3 rates have fallen to the floor. However, these interest rate differentials can certainly narrow overtime, if we continue to erode our emerging market risk premium through sound macro and governance policies.
 
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

Introduction
 
The post ‘Rexit’ rally in bonds has turned out to be much deeper and durable than almost anyone would have imagined on first assessment. While expectation of a more dovish governor seems to be the dominant trigger, the rally has also been helped by 2 other factors: One, the global chase for yields post ‘Brexit’ triggered by expectations of incremental easing by developed market central banks has rubbed off on Indian bonds as well. Two, the current period of surplus liquidity (though anticipated and temporary) has also contributed to renewed buying interest amidst participants.
 
In this note we analyze technical as well as fundamental factors influencing bond markets through both a short term as well as a medium term lens. The objective is to examine implications for bond strategies and hence for client action.
 
Technical Factors
 
Often when talking of the bond markets, we talk in terms of movement in 10 year yield. However, this paints an incomplete picture as the shape of the curve itself is constantly changing. This is important as relative performance of bond strategies change as the shape of the curve changes. The graph below tracks movement in spread between 30 year and 5 year government bonds. As can be seen the curve was continuously steepening (spread between the 2 bonds was widening) between September 15 and February 16, as market fretted over possible fiscal slippages and bond supply ahead (including UDAY bonds). However, once fiscal risks abated and RBI’s new liquidity framework of ensuring zero sustained deficit accompanied with OMOs was unveiled, the spread subsided and started settling down between 40 – 45 bps. This narrowing was also helped by the government and RBI cutting supply at long end of the curve over the first half of the auction calendar (April – September).
 
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As can be seen in the graph, the stable range of spread held between April – June has got broken in the recent sharp rally post Rexit. In our view this has been helped by a ‘re-rating’ of market’s view on incremental rate cuts from the new governor. Other factors like liquidity and foreigner participation were equally if not more supportive of shorter tenor bonds. What is ironical is that this re-rating happened even as Rajan was doing all he could to caution us against complacence and defending the appropriateness of the RBI’s interest rate stance. Indeed in the just concluded RBI policy, the central bank has retained its upward risks to CPI of 5% by year end. Also, unlike views in certain quarters, the government has retained the 4+/-2% CPI target for the next 5 years.
 
Nevertheless, we think the following technical factors are in play when assessing demand vs supply of government bonds:
 
1. OMOs: The RBI has conducted INR 90,000 crores of OMOs since start of this financial year. We estimate that it may conduct INR 50,000 – 60,000 crores each in the next two quarters. This assumes that the new governor is as reluctant as Rajan has been in cutting CRR. Should this not be the case, the quantum of OMOs could be lesser. It is to be noted that broadly speaking the RBI takes out between 9 – 11 years on average maturity via OMOs.
 
2. UDAY and SDL supply: SDL issuances thus far are around INR 88,000 crores. It is likely that another INR 2,25,000 – 2,50,000 crores are due for the rest of the year. Similarly, UDAY supply for the rest of the year could be upward of INR 75,000 crores (this number can increase depending upon whether or not Tamil Nadu joins the scheme). It is to be noted that all this supply is aimed at ‘investors’ who are also traditionally the largest buyers of long end bonds.
 
3. Investor demand: Demand from the largest insurer has been extremely robust at the long end so far. However, this is unlikely to sustain as we head later into the year. This is because other investment avenues (including equity and corporate bonds) will also vie for the investor’s cash flow. This is especially true as the government is depending upon market fund raising for a large part of its infrastructure spending this year.
 
All told we expect that the technical factors supporting curve flattening are unlikely to sustain over the next 6 – 12 months. Thus while sovereign yields may keep drifting lower, chiefly on RBI OMOs, the curve is unlikely to continue to flatten sustainably.
 
This is especially true if one were to keep a medium term perspective. As the graph below depicts, the total maturity of centre plus state government bonds will continue ballooning over the next foreseeable future; thereby significantly expanding the gross borrowing programs. On this note, a continued insistence on lower supply at the long end and thereby starving investor demand till date seems a little inexplicable despite earlier commitments towards continued elongation of issued securities. While tactical changes to the borrowing calendar to accommodate UDAY bond supply was prudent, continued lower supply at the long end risks increasing refinancing risk in the time ahead.
 
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Fundamental Factors
 
With the government officially communicating the 4+/-2% CPI target till March 2021, one has to anchor one’s fundamental view towards the likely evolution of CPI trajectory. In this analysis we will discard the mid-point (4%) as being too ambitious and focus instead on examining whether 5% can be achieved on a longer term sustainable basis. It must be noted that this analysis is distinct from what can happen to CPI trajectory over the next few months. Thus as pulses and vegetables dis-inflate, CPI readings are set to collapse significantly over the next few months, from the 6% plus reading recorded for July.
 
To start off, one must observe the composition of the current CPI. This can be explained via the graph below. The bars represent movements in the ‘core-ex transport’ index of the CPI. This index is relevant to gauge the broad momentum in the non-volatile items. It must be noted that in the case of our CPI, merely looking at core (or CPI ex food and fuel) is meaningless since some of the direct fuel items (like diesel and petrol) as well as their indirect variants (like public transport fares) are actually captured in the transportation index. As is plain from the graph below, despite significant volatility in the headline CPI (depicted by the line graph), the core-ex transport part of CPI has been stubbornly stuck above 5%. In such a scenario, should there be some spike in food and fuel prices, sustainability of RBI’s CPI targets will become a significant challenge. Looked at another way, stripped off the volatile food and fuel items, CPI is suggesting a marked unwillingness to break below the 5% mark.
 
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As an additional step, we also observe data on food inflation over longer periods of time. We have used CPI Industrial Workers (IW) as a proxy to CPI for this analysis since IW has historic data availability. As the graph depicts, in the past 20 plus years, there was only one 5 year period between 2000 – 2005 where food inflation dipped below 5% sustainably. For the rest, it has been above that mark with episodes of double digit inflation quite common as well.
 
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Another instructive way to look at this is in terms of possible causations. Intuitively wages should play an important role in determining food inflation; insofar as they denote purchasing power. Thus absent sustained gains in productivity and hence output, periods of higher wages should correlate with higher food inflation. Indeed, this seems to be the case when one looks at the graph below.
 
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Thus the sustained dip in food inflation in early 2000’s was indeed accompanied with a sharply lower agricultural wage growth. Similarly, over 2007 – 14 wages grew rapidly and so did inflation. Finally, the last couple of years saw a dramatic collapse in wages, and with it food inflation. It is nobody’s case that this level of rural wages should continue. Indeed, even if one were to take the government’s target of doubling farm incomes in the next few years with a liberal pinch of salt, it is reasonably clear that the current year will mark an inflection point in rural wages. This will be owing to better monsoons lifting farm income as well as a rebound in construction activity drawing labor away from the agriculture pool.
 

Given the above, it is hard for the new governor to have any amount of confidence towards sustainability of 5% CPI over the next 5 years; even though the target may be reachable for the current financial year. Further complicating the trajectory will be one-off factors like impact from pay commission (direct via allowances and indirect via higher purchasing power) and implementation of GST. Thus it is hard to build a case for sustained rate cuts from here, even as depending upon his/her level of ‘opportunism’ the new governor may indeed be able to slip in one more cut in the rest of this financial year.

 
Conclusion and Investor Implications
 
There are 2 large themes driving the bond market currently: One, RBI’s new liquidity stance and an accompanied ‘promise’ of OMOs. Two, expectations of more aggressive rate cuts from the new governor. In our view, the first of these is the more sustainable theme and the one on which investors with longer term horizons should be focusing on. The second looks much more tactical and refuses to give any benefit of doubt to the longer term wisdom of the new RBI regime. Investors looking to align to the first theme should inherently be suspicious with respect to the sustainability of the substantial flattening of the curve that has been seen recently. This is especially true if, as we believe, most of the technical factors supporting the flattening don’t seem durable with a 6 – 12 month view perspective. These distinctions are important since there is no persuasive case for not being invested in the market. 5 – 9 year government bond yields are between 50 – 65 bps over the repo rate and only 10 – 20 bps from the long end. These offer very good risk-reward especially if the theme ahead is of gentle drift down in yields on the back of better liquidity and modest rate cuts; rather than aggressive re-pricing to the RBI’s medium term reaction function. From a fund strategy perspective, investors should prefer active duration and short / medium term strategies as offering the best risk-reward going forward.
 

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 kept all rates unchanged today as was almost unanimously expected. Its assessment was also broadly unchanged from before, insofar that it continued to flag upside risks to its 5% CPI target by March 2017. This was despite recent improvements in kharif acreage and against some expectations that the central bank may deem risks as more ‘balanced’. The central bank broadly shares the market’s optimism over food inflation (recent uptick in prices is localized to vegetables and pulses) on the back of a strong monsoon progress. However, it is much less sanguine about the prospects of core inflation, notwithstanding recent softness in core CPI readings. It is watchful of effect on core CPI as the output gap continues to close and the full effect of the 7th Pay commission is felt. What is noteworthy is that while it will look through the direct statistical effect of the ‘house rent allowance’ component of pay commission, it will be watchful for any impact of this on inflation expectations. On growth, momentum is expected to quicken as normal monsoon raises agricultural growth and rural demand, while consumption generally also gets a stimulus from the pay commission awards. RBI’s accommodative stance is also expected to boost aggregate demand.
 
The stance of policy is retained as accommodative with two attendant legs to this: One, the RBI will await space for policy action. Two, it will continue to emphasize the provision of adequate liquidity. It may be recalled that the central bank had altered its liquidity stance in the April policy with a view to ‘lower the average ex-ante liquidity deficit in the system to a position closer to neutrality’ from 1% of NDTL deficit before. Towards this it has been proactive with OMOs since the start of the financial year. Thus INR 80,000 crores of OMOs have been already done in the financial year so far. This has neutralized the leakage from currency in circulation since start of the financial year and has allowed liquidity to temporarily slip into surplus zone. This is as per expectation and indeed it is quite likely that the so-called ‘core’ liquidity gets even better as RBI pays dividend to government. However, this will then start to deteriorate into FCNR pay outs and as currency in circulation picks up over ‘busy’ season. To that extent, the RBI can be seen as merely smoothening the liquidity cycle with an ultimate view to keep system at neutral (not surplus).
 
Takeaways
 
Today was Dr. Rajan’s last policy as the RBI governor. To that extent, the market had gone into it expecting to take what he says fairly ‘lightly’. Indeed, the market has picked up this habit for the last month and a half and has started to build in incremental easing from the new Governor. Reflecting this, the yield curve has been ‘bull flattening’ over this period. While the new Governor (and his disposition) is still not known to the market, there has been an important incremental development with respect to the possible future course of monetary policy. Thus, contrary to speculation in certain quarters that the CPI targets may be relaxed, the government has notified the 4+/-2% target for CPI for the next five years. Also future rate decisions will be determined by the monetary policy committee, the constitution of which is currently underway. This is not to say that a dovish governor cannot ease policy. As we have pointed out before, the new Governor can easily choose to focus on the upper band of 6%, instead of the mid-point of 4%. However, there would then be no doubt that policy will be set ‘opportunistically’ rather than from view of long term sustainability.
 
That said, it is probably prudent to orient portfolio strategies to what we definitively know. To us the most durable theme currently is the change in RBI’s liquidity stance and an accompanying guarantee of OMOs. Whether or not there are explicit meaningful rate cuts ahead will depend on whether the new Governor chooses opportunism or sustainability. Given this, we are the most comfortable in 7 – 9 year government bonds, especially after the last round of curve flattening. Whereas, we are looking at longer tenor bonds a little more tactically. From an investors’ standpoint it is probably advisable to focus on active duration and medium term strategies and not get excessively carried away chasing market momentum.
 
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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