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Investment Insights

Suyash Choudhary

Introduction

 

An integral part of our core portfolio view for most of the last one year has been yield curve steepening. In our view, it is logical to expect that towards end of a rate cycle, as net demand for duration wanes and participants start focusing more on ‘carry’. Indeed, despite intermediate disruptions, the 2045 vs 2020 GOI bonds have steepened by almost 100 bps over the last year and a half. In March this year we have tactically placed this call on hold and are no longer expecting the yield curve to steepen over the next few months. There are two key reasons for this call: One, market has finally priced out residual expectations of a rate cut post the February RBI policy where the central bank changed its stance to neutral. Two, demand vs supply for long end assets should be favorable over the next few months with strong seasonal institutional demand. An added potential enabler for lack of further steepening could be an (at least temporarily) unwinding of the so-called Trump re-inflation trade. To execute this view, we have increased duration chiefly via ‘spread’ assets (UDAY, SDL, corporate bonds); taking advantage of a widening of spread on these assets over March owing to very heavy pointed supply over that month. To be clear, the view is largely tactical and the yield curve may well restart steepening later in the year. This will also coincide with resumption of larger supply in spread assets as well towards the last months of the year.

 

This view is closely reliant on an underlying call that although RBI is done cutting rates, an actual rate hike is also not evident on the foreseeable horizon. Therefore, we are analyzing every incremental development (both locally and globally) just from a perspective whether we are getting any new information that would lead us to modify our view of no RBI rate hikes for the forecast horizon. This point is very critical to remember when one is, for instance, looking at incremental RBI communication. Clearly we are not looking for dovishness from the RBI, since we are clearly not looking for any rate cuts.

 

The Incoming Information From RBI

 

The recently released minutes of the April RBI policy have created a new flutter amongst market participants; just as each of the policies since December have done. Specifically, Dr. Patra (a RBI representative to the Monetary Policy Committee (MPC)) has referred to a preference for a pre-emptive 25 bps increase in the policy rate. In our view, while the comment obviously bears note, there is little fresh information embedded in these minutes. That the MPC is hawkish and has been concerned with inflation has been established all the way back in December. If anything, the standout in the latest minutes is that one external member, Dr. Dholakia, seems particularly dovish. Also, RBI Governor Dr. Patel himself seems far from contemplating a rate hike. The clearest indicator of this is the fact that he is still urging banks to cut lending rates. Given that monetary policy to a large extent works via the banking channel, Dr. Patel would not be wanting incrementally lower lending rates if he was seriously contemplating signaling a higher cost of capital via hiking the policy rate. The second most senior member from RBI, Dr. Acharya, is concerned about potentially narrowing output gap but is cognizant of the current uncertainties and is happy to focus on other issues for now; including resolving banking stress, mopping up surplus liquidity, and developing capital markets further. In total, then, there is little new information emanating from the recent minutes that should lead us to review our underlying premise. To recap, out of 3 RBI members, the governor is still arguing for incremental lower costs of capital via the banking channel, and the deputy governor is focused on other reforms and is acknowledging uncertainties. Of the 3 external members, one seems outright dovish at this juncture.

 

Going further back, we have been frankly surprised by the market’s surprise with the February policy. Anyone tracking RBI closely since the December policy should not have been realistically expecting a dovish outcome in February. The new information was really in the December policy when the RBI drastically changed tone from the October policy. Thus in October, there was a conscious attempt to defocus attention from the mid-point of CPI target (4%) towards the target band (2 – 6%). Alongside, there was an argument made that the so-called ‘real rate’ target for India can be set lower at 1.25% from the 1.5 – 2% band that seemed to be the target during Rajan. Come December, the focus was changed towards targeting CPI towards 4% and, by obvious implication, the real rate reference became meaningless. The presumed trigger for this change was the birth of the Trump re-inflation trade from November which pressurized global bond yields and led to emerging market outflows for that quarter. Looked at from this standpoint the hullaballoo around the February change in stance to ‘neutral’ was largely unjustified: if the target is closer to 4% and average CPI is forecasted to be 4.5% with upside risks then how can the RBI remain on an accommodative stance?. Similarly the April hike in reverse repo was purely operational as well: everyone in the market believed rates upto 1 year needed to be closer to the operative rate of 6.25%. The RBI merely arrived at an elegant way to do this that the market hadn’t thought of in its own series of iterations. Importantly, that doesn’t mean that the act provided any incremental information (or constituted a rate hike as some in the market seemed to think then).

 

A Quick Recap Of The Trump Trade

 

As discussed above the change in RBI stance between October and December was largely triggered by the Trump trade , in our view. To be specific, the trigger wasn’t the general improvement in global macros preceding Trump’s election; since the RBI was exceedingly dovish in October. Therefore, it is important to review progress on the Trump trade so far. To recap, there are 3 distinct legs associated with the Trump trade: 1> A net fiscal stimulus. 2> Territorial tax adjustments incentivizing flow into US 3> Re-doing trade agreements and changes in geo-political equations. The first 2 are potentially associated with a stronger US dollar and, in some scenarios, higher US rates. Whereas, the 3rd would get associated with a reduction in the growth stock of the world and an incrementally more dovish Fed. When embarking upon the Trump trade, global markets were largely focused on the first pillar of fiscal stimulus. However, the sequencing so far has been quite different. With an early defeat on the health care bill exposing rifts within the Republican party, an effective tax plan has been pushed back (although broad contours of this may be unveiled soon). Further, with the revenue savings envisaged through the health care bill no longer available to plough into tax stimulus, the strength of the eventual measures also stands questioned. Finally, Trump has waded significantly into geo-politics as well, which potentially creates a distraction from the ‘America first’ economic agenda. All told, the Trump trade is significantly fatigued in the near term. The same is evident in nominal and breakeven rates in the US, as well as the recent direction of the dollar. Interestingly, the RBI is as yet making no reference to this development; though this may be deemed prudent of a more medium term focused central banker.

 

Conclusion

 
A lot noise has been created through market’s interpretation of recent RBI policies. However, as we have discussed above, as long as one is clear what one is looking for from them, the noise is nowhere as large. Indeed, the new information from RBI was between October and December; and almost nothing since then. Specifically, what we are looking for is information that would lead us to revisit our expectation of no rate hikes in the foreseeable horizon. We have seen no new developments (locally or globally) that would lead us to do this. And so long as the repo rate remains at 6.25%, we think spread securities (UDAY, SDL, corporate bonds) are well poised on a total return basis (carry plus spread compression) for the next few months.

 

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 policy today was being looked at for one thing primarily: the RBI’s view and plan with respect to the massively excess liquidity sloshing around in the system since demonetization. The rate stance of neutrality has been well digested and market expected little incremental direction in this regard. Therefore, it is appropriate to start with RBI’s thoughts on liquidity:

 

Takeaways on Liquidity

 

The Reserve Bank of India (RBI) is clearly trying to map absorption tools to the source of liquidity. These are broadly as follows:

 
1. Surplus associated with demonetization, left over from natural drain from rise in currency in circulation, will be managed with variable reverse repo auctions; preferably of longer tenors.
 

2. Liquidity from ‘other sources’ (presumably forex flows) will be modulated under market stabilization scheme (MSS) using treasury bills or dated securities. While use of OMO has been mentioned, it was evident from the press conference post policy that the RBI will be quite careful and calibrated in using open market operations (OMOs) and will ensure that such operations are well flagged and will not disrupt bond yields.

 
3. Enduring surpluses from government operations will be managed by issuing cash management bills (CMBs)

 

Besides, it has narrowed the liquidity adjustment facility (LAF) corridor by pegging reverse repo and marginal standing facility (MSF) rates at minus 25 bps and plus 25 bps of repo rate respectively. Also, it is looking forward to the establishment of the standing deposit facility (SDF) for which government will have to move amendment to RBI Act. This will allow large scale absorption of liquidity in an uncollateralized fashion and will further strengthen RBI’s tool kit for liquidity management.

 

Takeaways from RBI’s macro assessment

 

The RBI continues to sound quite hawkish on CPI. It sees first half FY 18 CPI average at 4.5% and second half at 5%. While it says risks are evenly balanced around the trajectory at the current juncture, the list of upside risks seems much longer than that of downside risks. Amongst the former, the RBI mentions rising probability of El Nino, implementation of allowances under 7th Pay Commission, one-off effects from GST implementation, global commodity price rise, and geopolitics induced global financial market volatility with attendant spillovers. Whereas, downside risks mentioned are recent fall in crude prices and stepped up government procurement of food grains post a record production, which may mitigate potential food price stress ahead.

 

The following points are noteworthy:

 
1. The fall in household expectations of future inflation, which had dipped in RBI’s December survey, have picked up again.
 
2. The RBI has not taken well the recently announced farm loan waiver in UP (and risks of more of these to come in other states).

 

Conclusions
 

We have recently flagged a view that we believe curve steepening in India (which we have been aligned to for some time) is largely over for the near term (please refer our note “Just ‘Coz You See It (Doesn’t Mean It’s There): A Bond Update, dated 24th March for details). Further, we have built up intermediate maturities (8 – 9 years) in our bond and gilt funds largely via ‘spread’ assets (UDAY, SDL, corporate bonds); utilizing a window of aggressively pointed supply in these assets over March which had led to spreads on these rising sharply. The hypothesis behind this investment is predominantly that RBI remains on prolonged pause and thereby government bonds remain broadly range bound. So long as this is true, our portfolio strategy could benefit not only from higher carry but also from prospects of spread compression. It is to be noted that these bonds are at yields where small savings rate are. On a related point, the RBI has urged the government to cut small savings rate further (in line with the earlier declared formulae) to enable better transmission of previous easing.

 

Our marginal fear (marginal, since we were attributing a very low probability of this happening) going into the policy was of RBI using some disruptive tool like CRR hike or OMO sale of bonds to the market. Our biggest takeaway, hence, is that these haven’t fructified. Not just that, there seems to be a reasonably long term tolerance for demonetization related liquidity surpluses; with the central bank opting to continue term reverse repo auctions for this. OMOs will remain a reluctant tool, which also is positive from our current standpoint.

 

In sum, we would expect rates upto 1 year to rise in line with the new reverse repo rate; but for longer rates to remain relatively range-bound. In this construct, we would expect spread assets to outperform on total return (both from higher carry and prospects of compression). The trading range on the 10 year government bond may get decided over the next few weeks as absorption of the new auction schedule commences. Importantly if the recent disappointment to the so-called global reflation trade persists, and within this construct if India continues to receive the strong investor attention that it is lately getting, then the market may settle in a reasonably well-behaved range for the next few months.

 

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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