By: Punam Sharma
RBI Governor Urjit Patel, when he was deputy Governor under Raghuram Rajan, had once famously said that RBI is neither a hawk nor a dove, but an owl. As explanation he had offered that an owl is traditionally a symbol of wisdom and that owls are vigilant when others are resting. He couldn’t have put the role of a central banker more aptly. Indeed the analogy can helpfully be extended to bond investors as well, who have to be mostly perforce be classified into either doves or hawks. Whereas, what is infinitely more valuable in our view than a natural bias towards the market (that is bullish or bearish) is the existence of a robust framework with which to evaluate the market and keep updating this framework for incoming information. Such an approach would have served quite well over the past year in bonds, which has been marked with significant noise and related market volatility.
A brief history of RBI
Since October of last year, almost every monetary policy meeting has turned out to be quite eventful for the market. Amongst these the most noteworthy have been perceived to be the February one (where the RBI officially changed stance), and the April one (where the minutes came out to be substantially hawkish). In our view, however, the December policy was the one where the RBI had actually changed tone and subsequent ones were largely operationally reaffirmations of this tone. There was a marked contrast between October and December policy events. While the former was arguing for the possibility of a lower real rate target for India, the latter brought focus back on the need to bring CPI closer to 4% on a sustainable basis. And to us the only large event that could have triggered this hawkish switch (demonetization was a dovish event for monetary policy) was the political change in US and the prospects of heightened global financial volatility owing to the associated economic policies of the new administration. However it was clear by March that the momentum around these promised policies had dissipated. This was most evident in the reversal of the dollar and the re-igniting of financial flows back into emerging markets. Quite helpfully, the Indian bond curve had started pricing in lack of rate cuts. These provided us with both the opportunity and the trigger to build back duration in our bond and gilt funds.
With the Trump trade in steady remission, and the RBI seemingly overestimating near term CPI, we had argued in April against fears of a rate hike (please refer “Reviewing Our Fixed Income Framework For Recent Developments”, dated 24th April for details). The pendulum now has swung in the other direction with the central bank now dramatically revising downwards its CPI forecast and minutes of the June policy showing a vocal break in rank with at least one monetary policy committee (MPC) member. Bond markets smell rate cuts again with market expectation now inching towards a 50 bps cut over the next few months.
Recapping what we know
There is no doubt that the underlying environment is bond bullish. The first trigger for this was a turn to the Trump trade that substantially diminished prospects of global financial volatility and rekindled strength in emerging market flows and corresponding currencies. Added to this has been the turning over of hard data in economies like the US and the noticeable fall in prices of global commodities. Indeed, the US yield curve has flattened aggressively and seems to be actively challenging, at least for the time being, both the validity of the Trump trade and the Fed’s thesis that lower unemployment rate will cause inflation to rise down the line. Against this backdrop, our local CPI is significantly undershooting expectations causing the RBI to sound tentative with respect to its earlier hawkishness.
The only point of debate then is how much aggression, if at all, to ascribe to the RBI’s incremental reaction function. It is to be remembered that most of what RBI has ‘got wrong’ lately is largely with respect to its commentary and forecasts; not necessarily its actions. Indeed, a significant change now from most of the Rajan era of rate cuts is the practical stance on liquidity. While in theory RBI is targeting neutral liquidity, they have so far displayed remarkable patience with the demonetization related liquidity glut that has now persisted for more than 6 months. Indeed, this could possibly be the main reason why one doesn’t hear too many bankers clamoring for a rate cut anymore. It will be remembered that when RBI was cutting rates while keeping liquidity tight, bankers were quite vocal in saying that they need liquidity more than rate cuts.
It also has to be appreciated that the RBI’s tentativeness now is to a large extent justified. As it has maintained since December, it wants CPI to average closer to 4% on a sustainable basis. The current CPI prints contain substantial noise. The starkest takeaway is that the current farmer realization on selling crops and vegetables is apparently causing substantial unrest in many places. Apart from political dynamics of the issue, the spate of farm loan waivers currently getting announced seem partly to also attend to this unrest. It is therefore nobody’s case that the current food inflation can be extrapolated into the future. So there may be little information for RBI in the current aggressive disinflation in food. Similarly, it must be remembered that there are some discretionary policy choices that we have made which are all unequivocally good for the long term, but which require some growth trade-off in the near term. These include demonetization, GST, as well as the accelerated banking sector clean up that has now started. Thus while growth was already slowing over last year, one cannot excessively lament the larger slowdown now and lay the addressing of this at RBI’s door. This is because even if RBI wants to react to this temporary slowdown, it is well known that monetary policy may be ineffective for this; given that it acts with at least a 2 – 3 quarter lag on the real economy. By that time the temporary disruptions from these policies may already have passed over. In fact, and as noted by Deputy Governor Acharya, the banking transmission channel may be particularly impeded today given asset quality issues.
To recap, the environment remains decidedly bond bullish given the current dissipation in the US fiscal agenda, a rolling over of hard data and commodity prices, and local CPI substantially undershooting expectations. Within this framework, the debate is on how much more to expect from RBI. Complicating this analysis is RBI’s own current confusion and inability to be able to sift through the noise in the data. Happily, though, investors needn’t be confused at all. Active duration funds should have a long duration bias currently. Our preference is to construct this via a mix of spread assets as well as underlying government bonds. The focus here, though, should be on active duration management and the ability to cut out the excess duration risk later if circumstances change. Short term and medium term funds continue to look good given the still attractive spread between overnight rate and front end bonds.
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