By: Punam Sharma
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.
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.
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