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Investment Insights

Suyash Choudhary

The RBI has allowed an additional 2% carve out from SLR for the purpose of liquidity coverage ratio (LCR) maintenance, thereby taking the total carve out available to 15% of net demand and time liabilities (NDTL). Further, the RBI has made a proactive statement listing down steps taken thus far on liquidity (two Open Market Operations (OMO), term repos, LCR dispensation) and has provided further assurance that it “stands ready to meet the durable liquidity requirements of the system through various available instruments depending on its dynamic assessment of the evolving liquidity and market conditions”.
 
We discuss briefly possible implications of the move:
 
1. This is consistent with our thought that financial conditions are too tight and the RBI will incrementally be pushing against this tightness in the interest of financial stability (please refer our note “Too Tight? A Market Update”, dated 24thSeptember for details).  The premise is that market is currently overpricing incremental tightening in rates and liquidity given that financial conditions have already tightened significantly. The current move is one step further that will sit in dissonance with market thinking, but is consistent with our framework.
 
2. The headline number on liquidity that gets ‘freed up’ (in excess of INR 2 lakh crores) is probably a gross exaggeration. The move will likely largely be beneficial only to private sector banks that were facing LCR constraints and will ensure that the pressure to raise longer deposits (including CDs) subsides at least for the time being.
 
3. This move doesn’t create additional permanent liquidity. It is possible that the RBI may not feel pressure now to anticipate future tightness and proactively create permanent liquidity immediately. However, LCR dispensation is no substitute for permanent liquidity creation, and neither are term repos beyond a point. As said here many times before, core liquidity deficit will probably be higher than 2% of NDTL of banks by March if the RBI doesn’t take permanent infusion steps. Thus we still fully expect OMOs to happen, though they may be more spread out now that RBI has contained the immediate stress in money markets.
 
All told, the move is very important as a signaling tool for continued policy pushback against excessive financial tightening. It will alleviate stress in money market rates and front end bonds immediately (rates are down around 25 bps at time of writing). The continued underlying trade should remain one of fading the excess discounting of incremental tightening. This is best played through sovereign and AAA front end.
 
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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Sreejith Balasubramanian

India monsoon and agri snapshot: What does normal sowing in a deficient rainfall year mean?
 
The monsoon season (June to September), which coincides with the Kharif crop sowing season in India, draws to a close in four days. Its impact on crop output and rural consumption stems from the fact that rainfall during the season accounts for ~75% of the annual rainfall in a country where 50% of the area under food grain cultivation is still rain fed. This year, rainfall has been deficient for most part of the season. As on 25th September 2018, monsoon rainfall from 1st June is 9% below normal and 30% of the country’s area received below-normal rainfall. Temporally, each of the three months from June to August witnessed 5-6% deficient rainfall and September looks no different. It was particularly weighed down by consistently weak rainfall in East & North East India which has recorded 20%+ deficiency from the start of the season (Figure 1).

 

Figure 1: 2018 monsoon season rainfall till 25th September
 

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Benign impact on crop production and food inflation
 
The impact on crop production could be more benign than what the headline rainfall numbers imply. This is mainly owing to good reservoir levels and a strong pickup in sowing in August (Figures 2-7). That said, lower-than-expected yield from crops sown late into the season and the recent damage to paddy and cotton crops in the north western states of Punjab and Haryana (which together accounted for 15.3% of rice produced in FY16) from torrential rains could dampen the prospects of a bumper crop this year. Instead, crop production could be flat (the Government’s first estimates of production of major Kharif crops for 2018-19 is due this month).
 
Food inflation, even in the consecutive drought years of FY15 and FY16 (when monsoon rainfall was 12% and 14% deficient respectively), averaged only 5% and 5.9% y/y respectively in H2 (8.2% and 4.4% in H1). Better spatial and temporal rainfall distribution this year, adequate food grain stocks and supply side measures by the government should help contain prices of at least cereals and pulses, which are already quite soft.

 

Sowing: Better late than never
 
Crop sowing in July, when typically more than 50% of the season’s sowing occurs, was below normal this year. However, it picked up thereafter in August and total area sown is now above both normal and last year levels for most crops. This is particularly true for rice sowing, which is well above last year levels in most of the southern states and thus more than offset the minor shortfall in eastern states where rainfall has been consistently deficient this year. On the other hand, sowing of coarse cereals has been lagging this year as major producer-states Maharashtra, Rajasthan and Karnataka recorded mildly deficient rainfall and area under irrigation has always been very low. However, coarse cereals have a very low direct weight of only 0.45% in the CPI basket. The direct CPI impact from below-normal sowing of oilseeds could be similarly mild.

 

Figure 2: Sowing summary
 

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However, headline data may not capture the ground-level crop sowing dynamics. To verify, we look at how sowing progressed alongside rainfall in the top five producer-states (Figures 5, 6). The trend augurs well for food grain production this year.
 
Figure 5:Sowing of rice in the main states stabilized in July-August
 
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Figure 6: Sowing of pulses in the main states picked up sharply since July and has stayed high

 
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Reservoir levels
 
Reservoir levels, critical for irrigation during Kharif and Rabi (October-December) seasons, picked up since July. These are currently above the ten-year-average and last year levels in three of the five regions, despite falling slightly in September (Figure 7). The deficit in the western region is from lower levels in Gujarat and Maharashtra which are major producers, but currently lagging in sowing, of oilseeds and coarse cereals.
 
Figure 7: Overall and regional reservoir levels are high except in North and West India
 
graph1_2617

 
Conclusion
 
1. Rainfall during this year’s south west monsoon season has been mostly deficient. Despite this, Kharif season crop sowing has almost ended at normal levels due to a sharp pick up in August sowing and healthy reservoir levels.
 
2. This could effectively translate into flat crop production and impact food inflation (through cereals and pulses) only mildly, based on previous episodes.
 
3. Further, international weather forecasting agencies currently predict only a weak El Niño event (El Niño is historically associated with weak rainfall in the Indian subcontinent) by end-2018 or early 2019. This alongside the delayed withdrawal of the on-going monsoon should support sowing in the following Rabi season also (accounts for 50% of the annual food grain production) through soil moisture retention and higher reservoir levels for irrigation.

 
4. Moreover, comfortable food grain stocks with the Food Corporation of India (rice stock in September was the highest in five years) and softer global prices (particularly for rice) should help allay any potential price pressures from higher farm input costs (read oil) and Minimum Support Prices (MSPs) announced this year by the government.
 
5. The impact of MSPs is already incorporated in the RBI’s H2 FY19 headline CPI forecast of 4.8% and could only have an impact of 30-40bps this year, given historically inadequate crop procurement except for rice & wheat and the government’s proposal to cover only oilseeds under the Price Deficiency Payment Scheme.<   6. In this backdrop, any meaningful revival in real rural wages for agriculture labourers (currently negative) could be further away.   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

Too Tight? A Market Update

By: Punam Sharma

An underlying theme for the last few months has been progressive tightening in financial conditions. There are important channels of tightening and implications therein that one needs to be aware of:

 
1. With a substantial recent rise in US dollar and associated rise in emerging market (EM) risk premia, the environment for offshore financing has become extremely challenging. Presumably, this will curtail fund raising for all but the best rated entities.
 
2. liquidity conditions have been tightening rapidly. The first part of this was associated with the re-monetization phase of the system where ‘accustomed’ liquidity backdrop as reflected in very low rates on liability pricing started to get challenged, as the system started moving towards ‘normal’ liquidity levels. The next phase, which is underway, is associated with somewhat deficit current liquidity conditions, but extreme uncertainty with respect to forward liquidity. As pointed out before, unless RBI acts proactively, core system liquidity deficit will probably be in excess of 2% of net demand and time liabilities (NDTL) of banks by March.
 
3. Partly as a result of liquidity uncertainty and partly owing to revised rate expectations post recent INR depreciation, term spreads in the market have risen rapidly. At the time of writing, a 2 year AAA PSU bond is dealing at close to 9%. As discussed before, the swap curve is pricing in more than 3 back to back rate hikes from here. Primary issuances in the corporate bond market have slowed substantially versus previous years.

 
4. In an already tight environment, recent credit episodes may have further heightened liquidity preference of the market. In such a situation, the risk is for credit spreads to further blow out. Refinancing pressures may quickly mount and balance sheet growths may have to be rapidly curtailed.

 

Implications:

 

The objective of monetary policy is not to set the overnight rate alone but, more generally, influence overall financial conditions to achieve a particular growth / inflation objective. In the current context, India’s financial conditions are already rapidly tightening and actually call for more policy predictability than otherwise. Put another way, the objective of financial stability (which is the ultimate goal of any monetary policy framework, even if the proximate goal may be CPI targeting) may be in far greater threat from a rapidly tightening financing environment than from minor potential overshoots in either CPI or the value of the currency. Given this, in our view, one should expect less and not more hawkish outcomes of policy relative to expectations. Hence, it is very likely that market is overpricing future policy hawkishness (on liquidity and rates) especially in light of recent events. As before, investor preference should run from sovereign, to AAA, to lower rated. This is an exceptionally challenging environment for lower rated / high yield strategies, should this continued tightening of financial conditions not get arrested. This also makes for a very non-conducive growth environment and we fully expect growth to be impacted a quarter or so down the line.
 

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

The government announced some weekend measures to support the INR. These are largely to do with relaxations around external commercial borrowing (ECB), foreign portfolio investor (FPIs) holding concentration, and masala bonds. By themselves the measures have largely underwhelmed as reflected in the sharp depreciation in the INR on Monday morning. The other (unrelated) material development was the announcement of INR 10,000 crores of open market operation (OMO) bond purchases by the RBI, to be held this week.

 

We outline below our broad thoughts with respect to these announcements:

 
1. The issue never was the depreciation in INR per se; but rather the pace of depreciation. Over the past few years, INR had become distinctly overvalued. Thus the correction now is welcome from that standpoint. However, the pace of depreciation has been sharp lately. This, combined with unhelpful media comments from officials expressing no view or discomfort with INR, had given market forces a field day. Thus, whether or not the weekend steps were deemed effective, what is clear now is that the pace of depreciation has been noticed at the highest levels of policy making and measures are being taken finally. One understands that more measures are in the offing. All that is required is that the pace of depreciation gets arrested and INR starts performing in line with other similar emerging market (EM) peers. This is a reasonable expectation going forward.
 
2. While some re-pricing of future rate expectations from bond market perspective is natural given the sharp pace of depreciation, bonds have been lately matching INR movement almost paise to paise. This is basis a sharp re-pricing of rate expectations (swap curve pricing in more than 3 back to back hikes from here) and an emerging view that RBI will drastically change their liquidity stance. Indeed, emergency 50 bps hikes have also been discussed in certain quarters. In our view, as discussed here in previous notes, this is the wrong framework to apply in the current situation. The starting point of real rate is much different courtesy the CPI targeting regime put in place more than 4 years ago. Indeed, an interest rate defense now will be an implicit admission of a failure of  the CPI targeting regime. Rather, the RBI / MPC will evaluate the impact on CPI from recent depreciation of INR (and rise in oil) and act preemptively if their forward CPI trajectory is changing materially. It must be remembered that the August policy was perceived to be somewhat dovish insofar that CPI risks had been scaled down to ‘evenly balanced’ while the trajectory had only been modestly bumped up. Since then, INR has depreciated by 6% while India’s oil basket is up USD 5 per barrel. RBI’s Monetary Policy Report (MPR) of April 2018 assumes a 5% depreciation in INR adds 20 bps to CPI while a USD 10 move in oil adds 30 bps. The combined moves in INR and oil since August policy hence cumulates to a 40 bps impact on CPI. Against this, the July – September average CPI is currently tracking almost 60 bps lower than that forecasted in the August policy (note this undershoot also reflects in future CPI readings unless there is a future ‘reversion to mean’). Hence, the sum total of these developments at best merits an additional rate hike from the base line (in our case 2 instead of 1 till March 2019). However, there is enough reason to believe that the current more than 3 successive rate hike pricing is probably exaggerated.
 
3. An associated view of the market is that the RBI will now significantly tighten liquidity. In some quarters the OMO view has been jettisoned altogether. The last Friday announcement of the next OMO should help calm some of these fears. Again, just like in the case of rate hike pricing the question here is not whether directionally market is right in pricing in more hawkishness, but whether it is currently overdoing it. Thus as we have argued before, even if RBI wants to take rupee liquidity to -1% of net demand and time liabilities (NDTL), it will still need to conduct more than INR 1 lakh crores of OMOs over the second half of the financial year. We see no reason to change this estimate. However, what is also important to acknowledge is that these OMOs are necessary to alleviate crowding out in the bond market. Put another way, the policy attention now seems to have come on the rupee and the widening current account. With some hits and misses built in, we may now be in the last leg of the outlier INR adjustment and the associated panic. However, policy may as yet be underestimating the potential problem of crowding out that lies ahead of us. Such an environment argues for widening of spreads, and substantially so for lower rated assets. This tightness in wholesale financing will very likely be a large differentiator for credit profiles going forward. This is why one has to be very particular in where to invest. To reiterate, our preference runs from sovereign to AAA to lower rated. The ‘real credit, high yield’ space is best avoided in a financing environment such as this.

 

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

Introduction And Recap
 

The last few days have been nothing short of dramatic as far as financial markets are concerned. The theme of emerging market (EM) contagion has progressed sharply, this time led by Argentina, followed by Turkey. Policy rates in Argentina have been hiked by a dramatic 15% to 60%. Turkey has resisted thus far, but it seems likely that interest rates will have to be deployed despite massive political resistance to the same. Meanwhile, South Africa has registered back to back GDP declines; signaling recession from a technical definition standpoint. Closer home, Indonesian Rupiah has touched its weakest level since the Asian financial crisis. Finally, and most pertinently, the rupee has been progressively weakening setting new all time lows for the past few trading sessions successively. What hasn’t helped matters for us is that the recent episode of heightened EM contagion has been accompanied by a sudden and sharp reversal in oil prices. Thus brent oil prices are up almost 10% since mid of last month, with renewed fears of imminent Iran oil disruption weighing on the market.
 

Given all that is  underway, this seems an opportune time to review our big picture framework as expressed in our note “Making Movies : “The Big Picture”, dated 21st August. To recap, our core views were as follows:
 

1> The best in growth is largely behind us. Recent spurt in momentum has to be seen in context of pay back of almost two years of slowdown which was largely owing to domestic reasons. The phase of synchronized global recovery is now past us. This combined with recent financial tightening and other factors leads us to expect sequential seasonally adjusted slowdown later in the year.
 
2> We expected the current rate cycle to be up-fronted but shallow. We expected one last rate hike, most likely in the Jan – Mar 2019 quarter. This is despite a 100 bps plus acceleration in average CPI from last year’s almost unnatural cycle lows of 3.6% and largely owing to the fact that we expected the current comfort that RBI / MPC has with growth and output gap will change with slowing growth. To be sure, we had said that given the hostile global environment this won’t allow degrees of freedom to respond to growth. However, it may allow RBI / MPC to be more patient to let slower growth affect inflation.
 

3> Given rapidly dwindling core liquidity, and taking into account the INR 2,00,000 lakh crore expected rise in currency in circulation over second half of the financial year, we expected more than INR 1,00,000 lakh crores of open market operation (OMO) purchases from RBI over October to March.
 

The risk to the above framework we had expressed in the note was from external developments. Thus we had said “The one risk to the framework and view here is from further large disruptions to emerging market risk pricing, most likely from a further appreciable rise in the US dollar. If this were to happen, the RBI / MPC may have to abandon all other considerations and just focus on preserving macro stability. In this case the view both on shallow hikes as well as on liquidity injections may have to be modified”.

 

Reason Enough to Reassess?
 

Recent rapid developments have definitely moved in favor of some fructification of the risk factors to our framework. The idea here is to examine relevant factors to see whether a return to cash may be the most appropriate strategy. There are view-points already emerging that an interest rate defense may need to be mounted in India as well. Indeed, the 1 year swap rate has risen by around 30 bps over the past 1 month. Also, as the accompanying table illustrates this is now more than fully pricing in 2 back to back rate hikes in October as well as December ( 1 year swap is around 7.25% at the time of writing)

 
graph1_2617

 

The following points need to be highlighted:

 
1. The large wonder here is how did we come about to be in such a situation in the first place? From a place of extreme macro strength and rupee being a ‘low beta’ we are suddenly finding ourselves in a reasonably uncomfortable situation; despite having not taken any apparent macro missteps. Our best guess explanation of this is as follows: One, our macro strength over the past few years has been somewhat exaggerated by the dramatic collapse in oil prices. This allowed a better fiscal (higher tax on oil), current account, and CPI. The oil reversal is now weighing on current account first, then CPI. Fiscal drag is limited so far as the temptation to cut taxes is avoided. Two, owing to domestic reasons largely, India’s growth cycle has become un-synchronized with the rest of the world. This is a point we have made before in context of why we don’t expect the current growth momentum to last. However, this may also have played a part in widening our trade account. Thus, insofar as imports are correlated with growth, our recent growth recovery would have expanded our imports in a context where emerging market exports in general are slowing. This would have widened our trade deficit thereby pressurizing the rupee. Of course, a counterpoint made here is that our exports have anyways been slowing owing to local bottlenecks and hence the trade account may have been pressurized whenever economic recovery started. A related observation, made to us by a good friend, is this: for an economy like ours where one can hypothesize that domestic consumption’s dependencies on imports are high, a depreciation in currency may actually be equivalent to tightening and not loosening as traditional theory would suggest. This is because this makes imports more expensive thus denting demand, without providing the corresponding offset that would have been in place had we a well functioning export chain. Combined with the financial tightening already done via liquidity and rates, this is another argument against India adopting an interest rate defense for its current problem. It also further buttresses our core view that the best of growth is already behind us.

 
2. Comparisons to 2013 are almost completely without merit in our view. 2013 was the culmination of substantial fiscal stimulus and deeply negative real rates. Versus that, our fiscal largely is well behaved currently and real rates are substantially positive; even accounting for the expected rise in the current year’s average CPI. Thus an immediate intervention was then required from almost an existential standpoint. Even then, it was really the FCNR scheme rather than the interest rate defense that turned the tide for us. Whereas, the issue today is hardly one of existence. Indeed, the rupee has been considerably overvalued over the past few years. Thus the concern currently is only around the pace of depreciation rather than the direction. Also, even in this cycle there are examples of countries resorting to interest rate defenses with little immediate respite in sight. The one country example that obviously comes to mind is Indonesia which has fundamentally sound macros prima facie, but for a heavy foreign ownership of its bond market. The central bank there has hiked rates by 125 bps and the currency has still continued to weaken. Of course, the defense of the argument is to quote the ‘counterfactual’: that one doesn’t know what would have happened if the central bank hadn’t hiked.  However, the fundamental point here is that an interest rate defense in India for now will have little advantage but to increase cost of speculation in the currency by a small amount (unless one is talking of shock and awe hikes like 2013!). Also if the solution is the same as it was 5 years back, then one wonders where the benefits of fiscal consolidation and CPI targeting have gone.
 
3. The notable thing about the recent accelerated pace of rupee depreciation is that it hasn’t yet been accompanied by any significant foreign portfolio investor (FPI) outflow. Thus the bulk of the adverse flow seems to be on account of trade and a possible modification in importer / exporter behavior. Thus it makes imminent sense to offer special windows for large regular flows like oil payments. Without the backing of commercial demand for dollars in the interbank market, speculative interest to short the rupee may also find it difficult going; especially as the rupee isn’t as obviously overvalued anymore.
 

4. The RBI / MPC have a CPI targeting mandate. The currency stability mandate is only with the RBI and not with the MPC. The stated line on that also is that the RBI only intervenes to curb volatility and doesn’t take a view on the level of the rupee. Given this framework a rate hike via the MPC cannot be for currency considerations, but only if the weaker currency now leads to an assessment of higher CPI in the future. This is a reasonable causation to expect and, alongside higher crude prices, should be the logical way for the MPC. However, what muddies the analysis is that perishable food prices have remained very weak. As of date we are estimating a more than 50 bps undershoot to RBI’s July – September estimate of 4.6%. This undershoot opens up space for accounting for impact from weaker rupee and higher crude and still largely keep the second half CPI trajectory intact.

 

Conclusions and Takeaways
 

For the reasons mentioned above, we don’t think the current situation warrants an ‘interest rate defense’ in the traditional sense; at least as yet. There is no escalation yet in portfolio outflows that would give a sense that any sort of an unraveling is in order. Rather, the flow with respect to the trade account needs addressing which can be done via special windows. Give this, it is entirely possible that the market is over discounting the two successive rate hikes currently priced in. This will most obviously unravel should there be some stabilization / pull back in the rupee. However, should the situation worsen and the MPC indeed hikes basis a readjustment of their future CPI forecasts, we still think the current level of pricing more than covers it. Should the MPC hike twice again in the next two successive policies as swap pricing suggests, it would make four rate hikes on the trot. Given that peak growth is past us, this would probably tantamount to overkill.

 

The other issue is that of liquidity management. It is reasonable to assess that the RBI may be biased towards keeping rupee liquidity tighter given the environment. However, without at least INR 1 lakh crore of OMOs ahead, core liquidity deficit will rise to almost 2% of net demand and time liabilities (NDTL) of banks by March. Given this, it is hard to abandon the OMO view, even with the recent currency pressures.

 

Putting everything together, and acknowledging the sudden and sharp pain to portfolio positions over the past two weeks, we continue to like front end rates (up to 5 years) and more so now with the recent adjustment in rates. This is not to say that there may not be short term pain. However, once we account for what is already getting discounted in terms of policy rates, and the expected OMOs ahead, it is hard to discard 5 year government bonds at an annualized rate of 8.25%. Longer duration exposures need to be very tactical if at all given no macro reason to be bullish duration and given the fact that the bulk of state loan bond supply is still ahead of us. This should cause the yield curve to start steepening once the current turmoil stabilizes, from a currently very flat curve between 5 and 30 years. What also supports this view is that traditional balance sheet buyers of government bonds may have little appetite for duration given the underlying environment and the experience over the past year.

 

As before, the preference runs from government bonds to AAA corporate bonds, to lower rated. Given a rapidly tightening financing environment and our view of peak growth behind us, this is actually an extremely hostile environment for high yield credit strategies. Looked another way, the pressure on currency via an adverse flow environment and the problem of supply absorption of bonds is essentially one of lack of adequate availability of financing. This will most directly hit the lower rated/ high yield universe of credits. This basic fact needs to be acknowledged and accordingly portfolios need to be rebalanced.

 

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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