By: Punam Sharma
Expectations in the bond market with respect to incremental RBI rate action have been very volatile over the past few months. The RBI provided a rude shock in December by almost an about turn in its stance from October. Presumably this was done in anticipation of prospects of heightened financial volatility on the back of the so-called ‘Trump trade’. Since then the RBI has been largely consistent with its hawkishness, officially changing its policy stance to ‘neutral’ in February and then hiking the reverse repo rate in April. We have previously argued that both these measures were largely operational in nature and have provided little additional information as far as RBI policy is concerned. Nonetheless, the hawkish rhetoric has been continually up-scaled with an RBI member of the monetary policy committee (MPC) even suggesting the desirability of a pre-emptive rate hike in the April policy.
Market participants were justifiably spooked by the suggestion of a pre-emptive hike. We had argued then that there was very little fresh information here, just as there had been little fresh information since every policy after the December one (please refer “Reviewing Our Fixed Income Framework For Recent Developments” dated 24th April, for details). Our conclusion then was that, irrespective of the hawkish minutes, we don’t see a rate hike from the RBI over the foreseeable horizon.
Over the past couple of weeks, we sense the needle shifting the other way. From a position of being concerned about rate hikes, there seem to be some nascent expectations building for a rate cut later in the year. The obvious trigger for this is the massive undershoot in recent and next few months’ forecast on CPI inflation versus RBI’s near term expected trajectory. Thus while RBI expects 4.5% average CPI for first half of the financial year, market expectations basis recent data is tracking closer to 3%. Further helping the expectation is a substantial set-back to the Trump fiscal plan, given recent headwinds to the administration.
In our view, however, the bar for a rate change (either cut or hike) by the RBI is substantially high. Thus it is probably prudent to ‘fade’ excess bullishness in this environment, just as one was happy to also not accept extreme bearishness post the last policy minutes.
The bar for a rate cut
1. Current CPI readings, while will definitely flatter the averages for the current year, are not providing as much information about future inflation. This is because there is considerable ‘noise’ in the current readings. Core CPI and perishables are showing a welcome fall, but there is potentially still an element here related to demonetization. While re-monetization is ongoing, we are still more than INR 3,00,000 crores short on currency in circulation from where we were pre-demonetization. Further pulses inflation is negative double-digits owing to the massive disinflation that has happened here on the back of a bumper harvest. However, the price signal has been somewhat false as the tepid actual realization by farmers (below MSP in many cases) might prompt a shift away in cropping in the time ahead. Furthermore, rural wages and MSP seem to be on a steady uptrend which may warrant some caution down the line with respect to average CPI. Government measures like housing for all, while key to uplifting the general welfare of the people and hence an unarguable positive for the country, may shrink labor pools available for agriculture overtime and may steadily set wage floors higher. Hence while RBI may be steadily over-estimating near term inflation prints, it may be getting little information on medium term prints from these and hence may find it difficult to respond to these undershoots.
2. In our view, a significant reason for RBI’s sudden shift in stance between October and December was the prospect of heightened global financial volatility, with the obvious catalyst for this being the so-called Trump trade. We have discussed aspects of this trade before. In summary, a new fiscal stimulus over an economy already growing at trend could have lifted inflation and forced the Fed to act faster than usual. Thus RBI was prudent to shift focus towards macro-stability, as did the finance minister when he presented the budget. For the central bank this entailed shifting commentary towards achieving close to the mid-point of 4% of the CPI target range on a durable basis in a calibrated manner. Now as is well known the Trump trade is experiencing significant headwinds for now, and hence the associated fiscal agenda also is at least temporarily on the back-burner. However, this by no means implies that the agenda has completely dissipated. Indeed, there seems to be broad Republican support on getting something done over the course of the year ahead; even as the counters of what may eventually go through may differ from Trump’s initial plan. Also, while there is some rolling over on hard data, there seems to be general consensus that the underlying economy continues to grow well, whereas the unemployment rate is now at the level that is broadly consistent with long term equilibrium. Across the ‘pond’, the Euro zone has picked up pace as well with dissonance amongst ECB members on future course of policy now plain to see. Indeed, there seems to be a reasonable view building that the ECB will soon signal a taper to its balance sheet program. The point here is that while near term developments on the so-called global reflation and the associated Trump trade are sanguine, there is still enough reason to not write them off completely. Thus, from RBI’s perspective, it is still prudent to remain watchful for prospects of heightened global financial volatility, possibly later in the year.
3. Finally, the important point to note in this regard is that RBI policy is fairly loose currently, even though currency strength may have caused some incremental financial conditions tightening . Thus for all the talk of a neutral liquidity stance, the central bank so far has been extremely patient as far as draining out the demonetization related liquidity is concerned. Thus even today almost INR 3,50,000 crores of liquidity is sloshing around in the system. Indeed, the RBI had clarified in the last policy that they may want to use variable reverse repo only for demonetization related liquidity; thus implying a long rope for neutralizing this liquidity. As a result of these, bank lending rates for incremental loans have finally seen very strong transmission. Hence, while from a commentary standpoint it may appear that the RBI is ‘getting it wrong’, in actual fact it has kept the money market system extremely lubricated; thereby even ensuring a cycle low point in bank lending rates. So if comfort with respect to CPI improves, the central bank may merely be more content with leaving this liquidity as it is, instead of assuming any sort of an action bias on rates.
The bar for a rate hike
Even though at this juncture, given the new found sense of optimism amidst market participants, there may seem no merit in even discussing this argument; it is helpful to put the case out since it has important bearing on the future decision making of investors. However, given that this is currently out of context we will keep the arguments brief. Put simply, even when the current cycle turns it won’t be accompanied by the kind of ‘heating up’ in macro aggregates that typically accompanies a normal cycle turn. Rather any turn to the cycle is likely to be triggered owing to the new reaction function of the RBI and most likely in context of prospects of heightened global financial volatility. Thus any rate hikes in the future will, in all likelihood, come not because we have an inflation ‘problem’ but because the RBI now wants to keep CPI in a much tighter band than before. This would mean not only that the bar for the first rate hike is high, but also that the path of all subsequent rate hikes will be quite shallow. This is very important for investors to remember, should the debate swing back to fear of rate hikes.
The implication for investors
We have been comfortable with the idea of yield curve steepness over the past year. This has helped our portfolio strategies as the curve has indeed steepened, and substantially. Over March of this year we had also called for a temporary halt to the steepening trade; although it is likely that the trend resumes over the medium term (please refer ‘Just ‘Coz You See It (Doesn’t Mean It’s There), dated 24th March for details). In line with this view, we had also enhanced duration in our bond and gilt funds chiefly via 5 – 10 year spread assets. This has been a good tactical trade and we have booked profit on a substantial holding in SDL / UDAY and moved this position to underlying government bonds. We continue to like the maturity range of 5 – 10 years for now, and will reassess the view down the line.
For investors, it is important to fade the noise with respect to potential rate changes from RBI (cut or hike) and focus on a fundamental underlying point: that the yield curve today is steep enough to provide lucrative ‘carry’ and hence offers adequate protection against any sort of a moderate rate hike cycle that one may potentially encounter down the road. Thus there is more than a 100 bps spread between overnight and 3 year AAA rates. This carry buffer provides, in our view, adequate protection against any modest rate hikes that the RBI may potentially contemplate later on in the cycle. Conversely, the prospects for any sort of meaningful rate cuts are also quite low, and may not be worth chasing for investors.
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