By: Punam Sharma
To recap, over the past few months we have aligned our thinking on fixed income around a ‘real rate’ framework. The thesis has been that now CPI targets have been broadly achieved for a long period, the discussion should shift towards the appropriate real rate setting. To us, this decision should have been based on two factors: One, the state of the local economic cycle. Two, prospects of global financial volatility. Both these have conclusively argued for a lower real rate setting, in our view. Thus local growth has slowed over the past year and half just as the rest of the world has accelerated. And the stable global dynamics versus India’s real rate stance is amply visible in the massive accumulation of spot and forward reserves that the RBI has done since the start of this year. However, the RBI and the monetary policy committee (MPC) don’t seem to be operating off any consistent framework on real rates as the policy just gone by has amply demonstrated. Furthermore, the narrative around CPI also remains relatively tentative despite their forward projections ex- of central HRA largely hugging the target. Nevertheless, and whatever the reasons, we have misread the RBI and MPC over the past few months.
There are three new developments that merit attention. These are briefly discussed below:
1. G3: There are incremental developments in the G3 block that merit attention. In the US, the passing of the Budget resolution has raised optimism with respect to the tax plan seeing the light of day soon. Simultaneously, the decision on the next Fed chair seems imminent with some expectation that the new appointee may have a hawkish leaning. In Europe, the European Central Bank (ECB) is close to announcing some exit schedule on its quantitative easing (QE) program. Whereas, Japan is leaning the other way with Abe’s recent election victory paving the way for continued aggressive easy money policy from the Bank of Japan (BoJ). Amongst these, in our view, the US tax plan seems the most significant risk that can cause significant dollar strength to re-emerge with corresponding less attraction for emerging markets (EMs), including India. A more hawkish Fed chair by itself in absence of a tax plan and / or a credible rise in inflation, should only succeed in further flattening the US yield curve with potential consequences for real economic growth down the line. Whereas, the ECB taper may be long drawn and the BoJ aggression may partly counter-balance the winding down from the other 2 large central banks
2. MPC minutes: The minutes of the October policy were released recently. To us, there are no surprises there as far as the three RBI members and one external member (Dholakia) are concerned. However, the other two external members were more hawkish than what we would have expected. On balance then, the minutes indicated an even higher bar for further rate cuts.
3. Government’s growth push: The most recent development is the mega announcement by the government around public sector bank (PSB) recapitalization and stepped up spending over road networking. The government has announced a INR 2.11 lakh crore PSB recapitalization plan which comfortably engulfs even optimistic expectations with respect to any such exercise. Of this, INR 1.35 lakh crores is expected via recapitalization bonds. The modalities of these bonds are yet to be decided, barring an expectation that they are likely to be front-loaded. Presumably, they will be issued by the government or by some agency floated by the government. They may be directly placed with banks and the funds thus raised may be given back to the respective bank as equity capital. The following implications seem noteworthy:
a. We wouldn’t yet worry about the bond supply implication for this program. While in theory the recipient banks may sell these bonds to the market or be less inclined to buy new bonds in their investment books, it is equally likely that these bonds come under some lock-in or are part of a special carved out held to maturity (HTM) limits.
b. There is little implication here for headline fiscal deficit. These bonds are ‘below the line’ and only the interest cost associated with these will hit the fiscal. Also, the government may further ‘distance’ itself fiscally by bringing in a quasi government agency to issue the bonds. However, this may disappoint purists especially as we keep capital receipts like disinvestment proceeds ‘above the line’ it may be argued that the same treatment should be followed here. However, from a practicality standpoint and for bond market implications, this doesn’t add to government headline deficit.
c. However, this does potentially further raise the bar for the next RBI rate cut. This is because the government has now moved aggressively to address the problem of the credit multiplier. This creates further inertia for the RBI to act on growth, especially given the MPC’s new concerns on inflation in the context of rising global uncertainties. Thus even a weak September quarter growth print may sway the MPC lesser, now that they know that the government has strongly moved to address the credit multiplier. Rather, the RBI may be content for now to pursue with more gusto their ongoing project of ensuring more transmission into bank lending rates.
Implications and Portfolio Strategy
In order to clarify one’s thinking, one should park expectation of further rate action for now and then look for opportunities on the bond curve. Aided by RBI’s bond sales, rates even in the 5 – 10 year sector have also risen to between 80 – 120 bps over the repo rate. They are steadily approaching (if not already in) a zone where they will look reasonably attractive even without expectations of a rate cut. It should also be noted that if rates were to rise another 25 bps, there will be parts of the market rate curve that may start to deal at or higher than banks’ MCLR rates. The point here is that the structure of interest rates in the country, with CPI between 4 and 5% and corporate loan demand still likely to be subdued, itself doesn’t allow for much higher rates from here. Finally, some of the scare around fiscal deficit slippage has been addressed lately as well by the finance minister. Thus it looks like the government will adhere to the ‘glide-path’ of progressively reducing deficit even if there is some expansion from the budgeted levels. This means that the deficit should be within 3.5% this year and lower the next. With some adjustments to the voluntary bond buy-back program meant to smoothen future maturities, this may not entail any meaningful additional supply of government bonds in the last quarter of the current financial year.
On our part, we have steadily run between 15 – 20% cash in our active bond and gilt funds since the October policy. We have also moved almost an equivalent amount of bonds from the 12 – 13 year maturity bucket to the 6 year bucket. In line with what has been explained above, the intent is to focus on absolute value in an environment of minimal future rate cut expectations. We may look to add tactical ‘beta’ in the future should the framework undergo some change basis incoming information.
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