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Investment Insights

Suyash Choudhary

Introduction

The last month has been challenging for emerging markets. While some of these have had individual idiosyncratic issues, a renewed strength in the US dollar seems to be behind the general recent aversion to emerging markets. That strength itself is being attributed to various things: Growth prospects in the US versus other major economies seem more robust again as traction around the fiscal stimulus gains ground. This comes at a time when data from the other major economy, Euro zone, has slowed noticeably. Also, there has been a renewed sharp rise in US front end rates thus further boosting appeal for long dollar trades. Finally, there has been a further escalation in certain aspects of geo-political risks with the most recent trigger being US walking out of the Iran nuclear deal.

 

This emerging market aversion has led to some of the more susceptible economies struggling with the age-old problems of trying to protect their external accounts. As an outlier example, Argentina has had to undertake massive hikes in its policy rate since April. As an instance of how fortunes turn, this is the same country that had a 100-year bond issuance trading without a worry in the world till end of 2017. The worries for other markets are not as severe. But they still do exist. Indonesia for instance seems to be ‘in the middle of preparing firm monetary policy measures’, prioritization stabilization to ensure market confidence and macroeconomic stability is maintained. Indonesia doesn’t seem to have a macro issue per se. However, its bond market is heavily owned by foreign portfolio investors (FPI) who may be in search of some confidence from the central bank with the current global volatility underway.

 

Don’t Think Twice

 

The above is meant to flag a global theme underway currently, and not necessarily to draw parallels with India. However, this does mean that till the environment for USD funding stabilizes somewhat, India also has to heighten focus on macro stability. The rupee has been under pressure lately and has depreciated rapidly since early April. Over this period, it has also underperformed a lot of other Asian currencies. India is of course a deeper market and reliance on FPI money is quite miniscule. However, as discussed here before (please refer “You Want It Darker: A Bond And Macro Update”, dated 18th April for details) India’s basic balance has deteriorated over the past few months. Also, despite the rise in the US dollar, oil prices have risen sharply owing to geopolitical reasons. India’s sensitivity to higher oil prices, first on current account but then also on fiscal and CPI, is well known.
 

The minutes of the last MPC policy meeting made clear that there is a rising probability of MPC turning stance from ‘neutral’ to ‘withdrawal of accommodation’ in the June policy. Our base case has been for this to happen followed by an actual hike in August or October (please refer “Communication Breakdown? MPC Minutes”, dated 20th April for details). However, with the recent further rise in oil prices and incremental pressure on the INR, we acknowledge here the possibility that the MPC brings its action bias forward and actually hikes in June itself. For Deputy Governor Acharya, oil prices and assessment of growth recovery and hence output gap have been the two main drivers. In the last minutes he showed significant comfort with the growth outlook. Indeed, he assessed near complete closure of output gap basis his personally preferred ‘finance-adjusted measure’. Whereas, oil prices are more than 10% higher than the date of the last policy. Also the rupee has depreciated around 3.5% since then. Given these, it is possible that Dr. Acharya may be persuaded to cast his vote for an earlier hike. With two out of three RBI members in the MPC swinging for a hike, it may not be a tall ask to convince two other members to sway in this direction.

 

It must be emphasized that what is being discussed here is pure speculation, since it is always difficult to predict individual decisions. What matters more from investors’ view point is whether this has any implications for fixed income strategy. There are two points of relevance here:

 
1. An earlier hike may actually be desirable given the global backdrop. Financial markets (and, indeed, most other aspects of life) are largely about perceptions. Thus a ‘preemptive’ MPC already moving to address evolving inflationary risks may be perceived well by external watchers. Bond yields are anyway not getting priced off the repo rate. Term spreads even at the front end (2 to 4 year rates on government bonds and almost everything on corporate bonds / money markets) have no meaning and are at stress levels. Instead the problem is one of demand versus supply which in turn has caused a complete log-jam in the funding market. Hence, notional rate hikes at this juncture will have very little impact on bond yields at the front end, provided the accompanying communication is handled well and doesn’t disrupt forward rate expectations. Whereas if the MPC is deemed preemptive and, alongside some stabilization in the external environment, this stabilizes FPI demand for our fixed income to some extent; it may actually turn out to be beneficial for bonds.
 
2. What matters for investing today is not so much when the MPC starts to hike, but rather how many rate hikes the cycle is likely to have. This is because term spreads from current repo are at stress levels and market is already discounting a 75 bps odd hike in repo.  To that extent it is a strange cycle to begin with. The cycle is also strange from a standpoint that the economy is far from overheating yet. Thus output gaps, even as per RBI, are only now closing. Credit growth is only just rebounding. And CPI is still currently very well behaved. Also, the recent severe tightening of domestic financial conditions (spike in yields and funding market grinding to a halt) is bound to have an effect on growth down the line. Given this, we expect this rate hike cycle to be very shallow and estimate that the market is more than fully discounting what it’s likely to be. The only caveat here is a severe tightening of global financing conditions and / or a disruptive further rise in oil prices. Hence it is not the hikes in repo rate that should worry market participants even if a beginning is made in June, given the expectation of a shallow cycle and the upfront discounting already in place. Further, if RBI likely continues OMO purchases alongside whatever rate hikes are to come, it may actually turn out to be a better outcome for bond markets insofar as this addresses liquidity and the current demand – supply imbalance for bonds.
 
Conclusion (It’s Alright)

 

The bond market today is totally disconnected with the level of the repo rate. Hence, even if the MPC chooses to hike in June as a preemptive move to signal seriousness on CPI targets, this should be fine with the market. What really matters is that the accompanying communication is handled well so that the market view remains of gradualism. Indeed, basis local factors alone, the MPC may very well choose to wait longer. This is especially so as markets have already done RBI’s job more than adequately. Financial conditions have tightened significantly and will already likely impact growth down the line. However, the recent turn in global events may trigger the earlier move. Either way what only matters is that forward expectation remains of a shallow cycle. Also, RBI has announced the first OMO sooner than expected when system liquidity is still positive. This seems a preemptive move, and also a signal for bonds (please refer “RBI Fires OMO”, dated 7th May for details). Given higher currency leakage and shrinking balance of payment, the RBI will have to buy more than INR 1 lakh crore of bonds in the year ahead. Should it spread these evenly, then OMOs will likely continue. This is eventually much more meaningful for bond yields than the level of repo rate. Preference should remain for front end strategies (up to 5 years) given attractive valuations, a very flat curve, and no macro reason to buy long duration.

 

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

RBI Fires OMO

By: Punam Sharma

The RBI surprised markets by announcing an INR 10,000 crores Open Market Operations (OMO) bond purchase to be held on the 17th of May. While most market participants would have anticipated bond purchases by the RBI in the current year, given shrinking core liquidity in context of sharply rising currency in circulation and a dwindling balance of payment (BoP), the timing of the announcement comes as a surprise. The expectation was for the purchases to be back ended rather than now. Headline system liquidity still remains positive and the bulk of currency in circulation rise should be over for the first half year of the financial year, if trends have reverted to pre-demonetization levels.

 

Our key takeaways from the announcement are as follows:

 
1. This constitutes the second intervention from the RBI in the bond market in the past few days. It may be remembered that the regulator had recently relaxed FPI restrictions to allow them to invest in shorter maturity bonds than the previous minimum 3 year restriction allowed. Admittedly, the initial effect of the circular has been less than desired. This is largely for 2 reasons: One, the global backdrop is not very sanguine for higher allocations to emerging markets like India. Two, RBI has stipulated that not more than 20% of total investments should be in less than 1 year securities. This requirement is being deemed as onerous to comply with and media reports suggest representations are on to ask the regulator to re-consider this. Nevertheless, the timing of the FPI circular modification was a surprise as well given that it came at a time of rising global volatility and more uncertain FPI flows. If anything, going by past track-record, one would have expected the regulator to turn more (not less) conservative with respect to FPI participation. However, given that it happened, we were inclined to think of it as a sign that the frozen state of markets today was beginning to get addressed by the regulator. We would thus consider the OMO announcement as the second, and likely to be more effective, intervention in the same direction. It must be reiterated that this is being announced when headline liquidity is positive and we are close to peak currency in circulation for the first half, given historical trends.
 
2. This also likely settles another question that had occurred to us: when MPC turns stance to ‘withdrawal of accommodation’, could the RBI then also have moved liquidity stance to ‘deficit’ (say, back to -1% of net demand and time liabilities of banks) from ‘neutral’ today? With the announcement of OMO it is clearer that neutral stance will likely be maintained by the RBI even when the MPC moves to ‘withdrawal of accommodation’ stance. If this is the case, then one should expect OMO purchase in excess of INR 1 lakh crore over the course of the financial year. Also, the RBI may very well choose to take a forward looking view on liquidity and spread these more evenly through the year. In this case, the current OMO announcement may very well be followed up with more over the next few months.
 
The announcement again underscores the fact that bond yields are completely disconnected with the level of the repo rate. Thus the RBI is moving to create additional liquidity (with headline system liquidity already being positive) when one of its representatives into MPC already wants a hike and another is ready to change stance to ‘withdrawal of accommodation’. To us, the measure is intended more to unfreeze the bond market with the attendant toll on corporate bond financing that it is unnecessarily taking. Indeed the spread between repo and even front end (up to 4 – 5 years, where bulk of corporate and bank borrowing happens) is at levels last seen in the financial crisis times of 2013; while volumes have shrunk alarmingly even at the start of the financial year. Given this, it should actually be irrelevant to the market if the MPC decides to hike the repo rate over the next few months; provided that these rates are few and far between. This is because as far as rates are concerned, repo rate could already be 6.25 or 6.50% and levels would still be decent. What really matters rather is that RBI persists in fixing the current broken nature of the market. In this context, media reports suggest that there may be some relaxations provided to the ‘held to maturity’ (HTM) limits of banks to accommodate for government bonds that have to be kept to meet the ‘liquidity coverage ratio (LCR)’ requirement. If done, this would constitute as another significant intervention from RBI into the bond market, and would come as a big relief especially to public sector banks who have faced substantial mark to market losses over the past 6 months and have lost almost all risk appetite to participate incrementally in the bond market.
 

Investor Implications

 
The list of regulatory interventions in support of the bond market has grown considerably, and in a short span of time. Thus the government chose to borrow less, especially so in the first half of the year, and also reduced its bond supply in the so-called belly of the curve. There is also chatter of a sovereign issue at some point to further alleviate the excess supply in the local market (although this ‘rumor’ seems to have died for now). Then the RBI, despite taking a harsher stand before, allowed banks to spread mark-to-market losses. It then tweaked FPI participation criterion (more on this required though) and finally announced the first OMO bond buyback for the year, much ahead of market expectations. The strong takeaway from these definitely is that it is now well understood by the issuer as well as the regulator that there is a problem in the bond market and that it needs addressing. To us it is not as much about the level of bond yields anymore than the fact that the market for financing is largely frozen. The very sharp rise in short end yields has basically ensured that corporate borrowing, save in money markets, has almost come to a standstill.

 

The problem has to be looked at symmetrically: If memory serves correctly, members of the RBI have previously pushed against a hypothesis that monetary policy in India cannot target CPI. This presumably means that the channel of financing is alive and well in India and can curtail inflation through curtailing aggregate demand. If this is to be accepted then it must also be true that the recent very large spike in bond yields and the virtual freezing of the financing market should impact aggregate demand and hence growth down the line. For a recovery that was being termed nascent till not very long back, this is an unnecessarily headwind.  This is especially so since on paper the MPC is only now even contemplating switching stance to restrictive or ‘withdrawal of accommodation’.

 

From an investor standpoint, these recent regulatory interventions should definitely be construed as a constructive sign. However, this shouldn’t automatically be a trigger to buy long duration. There are enough local and global headwinds including higher oil prices and a recent upturn in local inflation momentum. Despite these headwinds, there has been a significant bear flattening of the yield curve over the past month or so. To us, there is nothing fundamental here and the flattening is on account of local market specific factors including:

 
1. Lower supply in the belly of the government bond curve under the revised central government borrowing calendar.
 
2. Duration switching by particular FPIs that sold short end and bought belly securities over a short span of time.
 
3. PSU banks having removed short end securities from HTM to sell in open market.
 
4. Bank traders having hit stop losses at short end, especially as hedging via swap started becoming inefficient.
 
5. Asset liability management (ALM) desks of some banks also apparently having forced into stop losses.

 

As a result of these, there has been excess supply at the short end of the bond curve (up to 5 years) over a very short span of time versus the belly and long end. We don’t expect this trend to last for too long, especially now that RBI itself has moved in to remove some of the pain of excess supply in the market. From a macro perspective, there is no reason for such a flat curve. While it may be argued that flat curves are logical with market forward pricing future rate hikes at the short end(like in US for instance), this also depends upon the starting point for rates and the quantum of hikes expected. Thus at current levels the front end of the curve is already discounting around 75 – 100 bps of rate hikes over a period of time (and probably 50 bps immediately). Also, given the lack of duration appetite it is likely that banks will also prefer the short end whenever they want to start adding to their SLR. Finally, the long end is currently getting anchored by large insurers / pension. Their demand is likely to weaken as we go deeper into the year.

 

For all these reasons, we think the current bear flattening of the curve should be faded. Instead, as levels start stabilizing, front end rates (up to 5 years) offer much better risk-reward. Purer carry strategies like AAA oriented ultra short / short / medium term funds also make sense given the very attractive carry over liquid funds and the fact that RBI seems to be finally moving to address the current logjam in the financing market.

 

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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