Suyash Choudhary

…But Seriously

By: Punam Sharma

Indian bonds have continued to fare quite well versus the rest of the world post demonetization, although with significantly more two way volatility. This is partly owing to the fact that incrementally the so-called ‘Trump’ trade’(higher dollar and US yields) seems to have tired out in the near term, as markets await more concrete information on policies. It is partly also owing to very light risk positions in the local market, as most traders wait on the sidelines for further cues. Finally, it is also partly because many participants still expect up to 50 bps rate cuts from the RBI in the next few months. The focus of this note is not to second guess market price movements but to only focus on an aspect of current thinking: the expectation with respect to RBI.


The RBI’s Evolving Framework  


Most market participants, including us, were shocked with the RBI’s stance in the December policy; the more so because it was unanimous.  As we have explained before, this was less owing to the lack of rate cut but more because the tone was distinctly hawkish and offered a reasonable contrast to the outcome and assessment in October. Thus in October, Dr. Patel had seemed to defocus from the significance of 4% as the CPI target, instead emphasizing the new official target of 4+/-2%. To us this had looked as if implicitly the target was being moved to an effective range of 4 – 6%. Secondly, the RBI team seemed to be making further room for rate cuts by conceding a lower real rate target for itself than before.


However, there have been at least three documents since then that to us seem to be tweaking the monetary policy framework: the December policy, minutes thereof, and finally a most recent speech by Dr. Patel. The focus now seems back on securing the mid-point of 4% of the CPI target range ‘on a durable basis’. This is very different from RBI being comfortable so long as the 4+/2% range is getting maintained. Further, and this could be a clue into why RBI is tweaking its framework, there seems to be renewed concerns with respect to global financial conditions posing ‘a threat to macroeconomic and financial stability’. If these concerns persist, not only would RBI want to ensure that the dominant theme is preserving macro stability (Dr. Patel has emphasized this a lot in the recent speech) but it may also follow that this may not necessarily be the right time to further dilute the real rate framework, as had been hinted at in the October policy.


Interestingly, despite these developments market expectations of incremental rate cuts have hardly been dented. Indeed, not only are expectations of easing alive, but it is also held that this will be ‘front loaded’. These expectations are largely based on a very legitimate view that RBI’s expectation of Jan – March 2017 CPI of 5% with upside risk will be undershot by a very wide margin. However, there is no recognition here on the other condition that Dr. Patel has now introduced; of securing 4% CPI on a durable basis. Even though the 5% mark in the near term will be comfortably undershot, there is almost no economist on the street who expects average CPI for next year to be lower than 4.5%. And yet, as mentioned, the rate cut expectations are very much alive. Indeed as the graph below shows, if one strips out the 2 items of CPI that have recently been notoriously volatile, the steady state readings (as also denoted by measures of core readings) are giving no indication at all of any comfort towards achieving 4% on a durable basis. Over and above, Dr. Patel sees upside risks (as mentioned in December policy minutes) to inflation from global volatility, full pass through of pay commission, some one-offs from GST implementation, and from signs of global commodity prices turning.



The only plausible reason for the current market expectation could be that the market thinks it likely that RBI’s framework will change again in February, as near term inflation readings undershoot its expectation. Else, it is hard to explain the complete apathy with respect to the medium term factors that the Governor of RBI is very explicitly flagging. Indeed, if RBI’s current framework is taken seriously it can be easily argued that the central bank (and the MPC) will disregard the recent fall in CPI, coming as it does on the back of extreme disinflation in very volatile items like vegetables, and will rather want to assess durability of sub 4% prints; especially in the light of the upward risks that the Governor has highlighted. Indeed, even from a practical standpoint, a rate cut now makes very little sense. This is because banks are sitting on massively excess low cost deposits owing to demonetization. The ask from them is not for either cheaper or more money. It is rather the availability of reasonable credit deployment avenues so that they are able to protect their net interest margins. In such an environment, an incremental rate cut has virtually no relevance at all.


What May Happen With Limited Rate Cut Visibility?


To reiterate, there is no strong view here whether or not there is a February rate cut. This is largely because we, as others, have also been surprised by the speedily evolving framework of the RBI. The intent only is to bring together elements of the evolving framework and caution that it may be worthwhile to start paying attention to them. What this does lead us to believe, however, is that scope for incremental rate cuts, if at all, is rather limited. This also follows from our assessment of macro themes in the year ahead, analyzed in detail in a recent note (please refer “Fixed Income Themes for 2017”, dated 28th December for details).


In our view, one has to be very cognizant of potential changes in the shape of yield curves towards rate cycle turns. Thus towards start of rate cut cycles, the curve flattens as market participants prefer to elongate duration. The reverse happens towards end of cycles, as market participants give up duration to seek shorter end ‘carry’ oriented positions. This is evident in the graph below that tracks 30 year to 5 year government bond spreads since January 2014.



As can be seen, in the first phase as our macro (current account and inflation) got rerated and market anticipated the start of an easing cycle, the yield curve aggressively flattened. However, since end of 2015, market has been continually testing a steepening bias as participants turned more unsure of incremental cuts. The curve steepened aggressively between late 2015 and end February 2016 as participants turned unsure on supply and rate cut dynamics. This trend got broken when RBI flipped completely on its liquidity stance and, in the process, turned supply dynamics as well via aggressive open market bond purchases. However, once the ‘shock’ of this change got digested the curve started steepening again. The next break came around Brexit / Rexit when market reworked its expectation of future monetary easing. However, this trend peaked out in September and the curve saw notable steepening once more after that. The point is that over the course of the year, and despite intermittent volatility, the yield curve has broadly continued steepening. This is despite major correcting events in between including a complete turn-around in RBI’s liquidity stance, a reduction in long end borrowing program, and a change in RBI’s leadership.

Deriving from the above, if basis RBI’s new evolving framework and heightened global risks, market starts getting more comfortable with the idea that we are close to the end of the rate cycle, then it is very likely that the underlying trend last year of curve steepening starts asserting itself more meaningfully. This is especially true now because front end rates may find a better anchor given that system liquidity is expected to be positive for the foreseeable future; whereas prospects for bond purchases from RBI (that support duration bonds ) may be quite low. It is also to be noted that market participants haven’t seen a true bottom to the rate cycle in a long while. The 2013 turn to the rate cut cycle arrived disruptively via a one-time shock to the system; rather than via a slow bottoming out of policy rates. Thus the usual anchors around shapes of curves that may exist today, may need substantial revisions in the time ahead.


Reflecting this framework, our bond and gilt funds are now very overweight front end bonds up-to 5 years; with very little exposure to long duration bonds. As always, and in line with our active duration mandate, we will revisit this position should any of the assumptions in our framework were to substantially change.


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