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Investment Insights

Suyash Choudhary

Gravity : A Year In Bonds, Macro And More

 
Introduction

 

Just by looking at year opening and closing bond yields, one may be forgiven in thinking that not much has gone by this year. Thus the 10-year government bond yield between start of year and at the time of writing has barely moved at all. As we know, however, this masks a greater than 100 bps range intra year and was accompanied by nothing less than full drama with respect to Indian and global macro. The theme of this year end piece is ‘gravity’. Apart from being the title of a favorite song, this word also marks a lot of goings on this year both in macro as well as in markets.

 

Shifting Sands

 
To us the biggest theme of the year was the changing narrative on global growth. It is useful to put this in context by recalling some recent history. Post the Chinese devaluation and the associated force of gravity on commodities, the world entered a period of growth scare. However, we were pulled back from this through implicit policy coordination amongst the world’s large economies. Thus, China launched a mini stimulus to backstop growth deterioration whereas the US ‘talked down’ the dollar somewhat which resulted in some easing of global financial conditions. From there, the world entered into a phase of largely synchronized recovery which lasted till the better part of 2017 and which was possibly aided by the change in US presidency towards a more regulation light and pro fiscal policy. The one economy that bucked this trend of synchronized recovery and buckled to the force of gravity, however, was India. We actually slowed during this period and materially so. Most of this is probably attributable to India specific factors like demonetization and the potential uncertainties around GST. However, the momentum had somewhat begun to slow over 2016 itself. Nevertheless, as these factors started stabilizing India showed a strong recovery over first half of 2018.

 

Starting 2018, however, the world narrative on synchronized recovery started to shift. Thus the US was accelerating largely on a late cycle fiscal stimulus implemented by the Trump government. But many parts of the rest of the world, notably China, had started to feel some gravitational pull. This shift in theme had two major implications for emerging markets including India. One, export cycles started slowing with a decided skew getting created in world demand. Two, since growth was being led by the US, the dollar started to rise materially. Also, quite unhelpfully for India oil prices spiked during the year even has metals and soft commodities were largely subdued. This combination of rising dollar and higher crude was a potent mix for many emerging markets and particularly for large oil importers like India. There was rapid tightening in our financial conditions specifically over the 3rd quarter of the calendar year which, alongside a slowing global export cycle, had obvious implications for growth.

 

Over the last couple of months of the year, there seems to be another shift to the global narrative. Gravity is after all a universal force. The phase of synchronized recovery that had given way to unsynchronized recovery for most of 2018 seemed to be moving into some sort of synchronized slowdown.  Thus parts of the US including housing and auto as well as business investments more generally seem to be losing momentum. Growth forecasts for next year are closer to the perceived longer term trend rate of growth versus the fiscal induced much-above-trend growth this year. Helping the narrative along are minor inversions in the US yield curve seen lately. At close of year, the markets have almost fully priced out any rate hikes from the Fed next year. The dollar versus emerging markets has come off as well thus helping financial conditions everywhere. Oil has experienced a brutal force of gravity, falling more than 1/3rd in a couple of months. Given these, a lot of pressure on India has subsided. Helping the turn has been our food CPI experiencing an exceptional gravitational pull as well and collapsing into deflation, thereby keeping us on course for a second successive year of sub 4% CPI.

 

The RBI’s Reaction Function
 
A lot of critique is opportunistically piled on to RBI’s door for consistently overestimating CPI, and sometimes remarkably so. However, in most cases this has been true for private forecasts as well. These errors tell more about the nature of the forecast variable itself rather than the process of forecasting. Nevertheless, there are enough lessons from CPI targeting thus far to start to appreciate that it is a difficult variable to forecast and even more difficult to target. So far most of our history with CPI targeting has been sanguine and has coincided with large downward changes in minimum support price (MSP) growth and rural wages. There have potentially been efficiency gains as well with better management of cereal inventory and possible fall in transportation costs. Many of these, it is to be noted, have little to do with monetary policy. The point here is that the efficacy of monetary policy to target a variable that is heavy on food and fuel and may also be responding to changes in cost of financing in the informal economy, may be limited. Thus the recent sanguine phase shouldn’t be wasted and the RBI/MPC should potentially start targeting some band on a consistent definition of real rates and link it to the assessed phase of the business cycle. Thus it can target a higher real rate band in a closed output gap scenario and so on. But we digress, and further exploration of this theme is best left to a future note.

 

In some ways, MPC’s rate setting has been the best inasmuch as it has tended to not react to extremes. Thus when talk was of ‘deflationary forces’ affecting the economy around mid of last year, it avoided reacted excessively, choosing to reluctantly offer one rate cut only. Then in the run up to this October’s policy when the consensus wanted substantial rate hikes to defend the rupee, it chose to focus on underlying CPI and merely contended itself with changing stance. This slower moving reaction function seems more apt when changing policy rates, which themselves only impact the real economy with a 2 – 3 quarter lag. If one has to fault at all, one could potentially have asked for more patience last year when RBI absorbed INR 90,000 crores of permanent system liquidity via open market operations (OMOs) when currency in circulation (CIC) trends were still stabilizing and when its own analysis had deemed this excess liquidity as being largely non-inflationary. Similarly, one could have argued that pace of OMO purchases could have been stepped up earlier in the current year itself responding to the evolving balance of payment (BoP) situation and with the CIC calculations already pointing towards sizeable deficits later in the year. Nevertheless, the important thing is that the approach on liquidity is now solidly proactive with the central bank working on anticipated drain and not hesitating in providing forward guidance on liquidity creation.

 

There is a role for gravity here as well. Lately the narrative with respect to the RBI versus government has turned somewhat too simplistic. The primary hypothesis has been that the government wants RBI to do its bidding in a variety of ways and that the recent change in Governor will help facilitate these demands. These are matters of utmost gravity and one has to exercise due prudence in making such interpretations. First, there is enough evidence already of full continuity in monetary policy under the new governor. The preference of tool for liquidity creation remains OMOs rather than CRR, whereas the potential for monetary easing if CPI moves as envisaged had already been flagged by previous governor Patel in his last monetary policy. So to say that potential for monetary easing has now opened up is untrue. Amongst non-monetary policy considerations, a big item of debate has been the view that RBI is overly capitalized and that some part of its reserves should thus be transferred to the government. A committee, composed 50% of current and ex RBI officials, has been formed that will study the matter and opine in due course. Again it is hard to envisage how this could have been much different had there been no change in governor at RBI. The point is to caution against excessively simplistic causations that give no benefit of doubt to what is the most important policy maker and an important custodian of the country’s macro-stability, the government.

 

The Goings On In Credit

 
The latter part of 2018 witnessed an important domestic development for our money markets: a wobble in the housing and non-bank finance (HFC / NBFC) market. Apparently triggered by default by a large NBFC, the financing market for all but the bluest of chip HFC / NBFCs seemed to dry up for a period of time over September – November. Thankfully, the financing issues have now been largely arrested without any major systemic accident, chiefly courtesy proactive liquidity provided by state run banks. As gravity presumably strikes to future balance sheet growth and as more generally credit flow to certain sub-sectors slows in an environment slowing growth momentum, it remains to be seen what happens to general asset qualities in some segments going forward.

 

An important development was in the credit markets in India. As risk aversion led by the HFC / NBFC episode took hold, one would have reasonably assumed the lowest rated assets to do the worst. Instead, we saw the spread between AA and A rated papers on an average dropping by a full 100 bps during this period! Exploring this unexpected imposition of gravity further, we found the underlying reason to be quite mundane but nevertheless concerning. A bulk of A rated and below category papers don’t trade and hence there is no actual price discovery in such papers. Whereas, AA had better price discovery from the market and hence felt the impact of the environment. This led to the massively counter-intuitive narrowing of spreads between the two.  It provides obvious food for thought to investors who anyway should be looking to move towards quality fixed income given the underlying macro backdrop of slowing growth and a more constrained fund raising environment for parts of the system.

 

The Way Forward

 

Given the massive shifts in macro and themes over the past year itself, any year ahead prognosis has to come with significant caveats. Thus ideally forecasts should be made for the real long term (when either one dies or averages catch up) or not at all. Nevertheless, fortified with year-end cheer and protected with assumptions generously made, we shall go ahead with at least a thesis for the next year. Thus the start point for the year is a possible phase of synchronized global slowdown developing. This largely means that the US is finally responding to the gravitational pull already in play for most of the rest of the world. If this sustains, it is obviously bullish for bonds including in India. Thus, our view for some time already has been that peak growth in India is past us and that owing to recent tightening of financial conditions and slowing global trade cycles, incremental momentum is set to slow. This saw early evidence in July – September growth data itself. Combined with the global backdrop of demand concerns and easing commodity prices, as well as local CPI also meaningfully surprisingly lower, this means that it is reasonable to look for easier monetary policy ahead. Indeed, our swap curve, which was pricing in more than 3 successive rate hikes a few months back, is already pricing in monetary easing over the next year. While the fall in bond yields has also been dramatic from the top, there is still more than enough value in quality bonds for the asset allocator, if this is indeed the turn of a global economic cycle. The current dramatic pace of OMOs will of course subside come April. This will probably narrow some of the very large spreads on AAA and state government bonds versus central government bonds. But if the global theme remains that of slowing growth and inflation and potential changes to reaction functions of large global central banks, then OMOs should not be the only dominant variable in thinking about the market. Neither is value on a risk – reward basis only limited to one area of duration. The one risk to be continually monitored in India will be the evolution of fiscal stance both in the run up to as well as post the general elections scheduled in the year.

 

The global theme itself may take one of many directions. The first, and probable best case, is that the gradual de-acceleration sustains which leads the Fed to back off completely and heralds a period of contained dollar strength and commodity prices. This will be good for emerging market bonds including India and will provide policy space  to ease for local reasons if required. The second is that this slowdown accelerates accompanied with higher financial market volatilities. In such a case dollar may get safe haven bids and may strengthen alongside falling bond yields. However, this kind of dollar strength may not deter emerging markets like India from easing policy given that commodity prices will be weak in such a scenario and local growth impact could be substantial. The third could be that the current scare fades, trade tensions resolve, the recent resolve from China for measured accommodation yields results and the current deflationary fears fade completely. In such a case, there may be no case left for long duration bonds.

 

All told and taking into account recent events, it is prudent to for now stay with the theme of slower growth and higher market volatilities. In such a scenario, some significant adjustments need to be made to fixed income allocations away from credit and into quality fixed income. Most asset allocation has leaned heavily towards credit over the past few years.  This has been consistent with one phase of a cycle and needs to change if the cycle turns. Thus slowing growth and rising volatility is almost always associated with rising credit spreads. This is already happening elsewhere in the world but has barely started in India. Also, as in the case of A and below mentioned above, in some cases spreads have unjustifiably compressed in India only reflecting lack of liquidity. Thus there is significant price distortion in the lower rated part of the market which first needs to correct to earlier equilibrium and then rise further to reflect the new realities in credit markets.

 

While signing off one can do little better when summarizing risk versus reward in fixed income in context of the evolving macro backdrop, than quote from the same favorite song that has been the inspiration for this note (minor liberties taken with the lyrics):

 

“Twice as much

Isn’t twice as good

And can’t sustain

Like one half could”.

 

Wishing you a very happy new year!!!

 

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 security may or may not continue to form part of the scheme’s portfolio in future.  Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. 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

The Reserve Bank of India (RBI) recently cut its CPI inflation projections for Q3 FY19 sharply, by 90bps in October and 120 bps in December. It cited ‘heightened short-term uncertainties’, amidst unusually low food inflation and volatile crude oil prices. In this context, we look at RBI projections in the last one year – the magnitude of its revisions, directional bias (if any) and precision when compared with the actual numbers. However, for a holistic and fair evaluation of the projections, it is important to factor in the economic context and the corresponding uncertainties it entails. For this, we do a detailed study of the RBI’s fan chart of CPI projections – from the bi-monthly Monetary Policy Committee (MPC) resolution statement – to gauge the RBI’s thinking about the future CPI trajectory, the underlying degree of uncertainty in its projections and how this changed in the last one year.
 
What do the fan charts tell us?
 
Figure 1: RBI’s fan chart of quarterly CPI projections
 

graph1_2617

 
Source: RBI (MPC resolution statement, 5th December 2018). Note: Data for the 50% CI range is obtained based on visual observation.
 
The RBI’s fan charts on quarterly headline CPI projections (Figure 1), tell us two things – 1) the baseline projection (also mentioned in the statement text) and 2) how confident the RBI is in its projections. For the latter, we look at the range of outcomes associated with a particular probability of occurrence. For e.g., the 50% Confidence Interval (CI) below, on which we focus our study in this note, implies there is 50% probability that the actual outcome will be within the range represented by the thick red shaded area. Higher the width of the range (upper bound minus lower bound), greater the uncertainty or lower the confidence.
 
To decipher the trend in the direction, magnitude and uncertainty of projection-revisions, we look at the data through a series of charts below. Important to note is the RBI’s CPI projections that matter most are the antepenultimate (second before the last) and penultimate (one before the last), given the final projections are either made well into or after the quarter ends.
 
Upside bias despite sharper downgrades
 
Figure 2 depicts the CPI projections for a particular quarter vs. actual, at the last 3 MPC meetings when the forecast for that quarter is provided (after which actual data becomes available), and the economic context.

 
graph1_2617

 
Source: RBI. Note: Q3 FY19 actual data is the average of October 2018 and November 2018 readings.
 
The key observation is:
 

• The consistent upside bias (over-estimation) in RBI’s projections from Q4 FY18. However, it must be noted that most estimates on the street during the period were also high, given food inflation has stayed unusually soft.

 

Uncertainty fuels volatility while the unusual fuels the margin of error
 
Higher uncertainty (crude oil price, exchange rate) and the unusual (soft food inflation) has defined India’s economic landscape in the last few months. The impact of this feeds into projections as well. See Figure 3 below, which depicts the magnitude of difference in RBI’s projections vs. actual.

 

Figure 3: Recent revisions – impact of the uncertain and the unusual
 

graph1_2617

 
Source: RBI. Note: Q3 FY19 actual data is the average of October 2018 and November 2018 readings.
 
We observe:
 
• Revisions have been quite heavy and volatile

 
• The margin of error, particularly in the projections for the last 2-3 quarters, have been high
 
• The upward bias in projections

 

To understand this further, we look at the 50% CI range-width for the last three projections of a quarter (Figure 4). While lower width represents lower uncertainty, it should be noted that the width typically reduces as we move into the quarter because actual CPI and market-price data becomes available. Q2 FY19 was an exception, a sheer case of heightened short-term uncertainty.

 

graph1_2617

 
Source: RBI. Note: All CPI fan-chart related data is based on visual observation of the chart in the MPC policy statement
 
We now look at uncertainty from a different angle. For this, we address the question ‘How confident has the RBI been, at each of its MPC meetings, when making CPI projections for the immediate three quarters?’.
 
Figure 5:  Uncertainty when making projections at the last nine MPC meetings – above average in August and October 2018
 

graph1_2617

 
Source: RBI. Note: Dotted lines above depict the average for each of the category.
 
Two major inferences from Figure 5 are:
 
• High fluctuation in the degree of confidence within current and next quarter projections vs. quarter-after-next projections
 
• Jump in average uncertainty from the current quarter to the next quarter projection, but only a moderate increase from the next-quarter to the quarter-after next projection.
 

Thus, although the RBI’s confidence is higher when making current quarter projections (which is reasonable given availability of concurrent data), it’s degree is very volatile. Particularly, August 2018 and October 2018 witnessed a sharp fall in RBI’s confidence when making current and next quarter projections. However, as we mentioned earlier, a fair and holistic evaluation of the projections demands an understanding of what transpired in the real economy. In this regard, the table below (Figure 6) captures the volatility in specific economic variables then and how this justifies some of the uncertainty RBI faced. Nevertheless, the magnitude of revisions, the margin of error and even the general upward bias are all still debatable.

 

Figure 6: Economic variables at the last four MPC meetings

 
graph1_2617

 

Source: RBI, CEIC, IDFC MF Research         Note: Red color = Increase; Green color = Decrease
 
The bottom line
 
Fan-charts, of particular interest due to RBI’s recent sharp downgrades of CPI projections, reveal critical information. The key takeaways from analysing the charts released by the RBI in about the last one year are:
 

    • Consistent upside bias in projections, despite sharp downgrades
     

  • • Sharp revisions to projections more recently
  •  

  • • Higher margin of error (vs. actual), especially in the last 2-3 quarters
  •  

  • • Higher short-term uncertainty evident from episodes of a) higher confidence in projections revised in the wrong direction and b) increasing uncertainty (ideally should be decreasing) about a quarter
  •  

  • • Volatile degree of confidence when making current-quarter projections; particularly low confidence recently at the August 2018 and October 2018 MPC meetings
  •  

  • • The uncertainty around crude oil price and the exchange rate, and the unusually soft food inflation, partially justifies the recent revisions but their magnitude, margin of error and general upward bias are debatable.

 

Finally, there could be two types of errors:
 
• The first is caused by the false-perception of higher certainty. This could cause an error in the direction of the projection made (e.g. the penultimate projection for Q4 FY18).
 
• The second is caused by higher uncertainty. This could cause revision in a projection, despite being in right direction, to be insufficient in terms of its magnitude (e.g. revisions in projections for Q3 FY18, Q1 FY19 and Q2 FY19).

 

Based on the above episodes, it seems the RBI is committing more of the latter. However, this could be because the unusual persistence of softer food inflation continues to surprise.
 
Thus, it is important to keep in mind the above inferences when interpreting RBI’s CPI projections and acknowledge the higher scope and margin for error during uncertain times.

 

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 security may or may not continue to form part of the scheme’s portfolio in future.  Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. 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.

Tag:

Suyash Choudhary

Upping its recent proactive stance on liquidity, the RBI announced an even higher pace for Open Market Operation (OMO) for the rest of the financial year. Thus it increased the quantum for December by INR 10,000 crores to INR 50,000 crores. It also announced INR 50,000 crores for January and guided that it will ‘consider similar quantum of OMO purchases until end of March 2019’. Of course, relevant usual caveats around currency in circulation (CIC), forex operations etc. have been given. It may be remembered that one of the key highlights of the December policy was Dr. Acharya saying that the increased frequency of OMOs may be required till March. At the time the market had assumed this to mean the INR 40,000 crores announced OMOs for December would get replicated over January to March. The current announcement ups this by another INR 10,000 crores per month for this period. If this revised pace indeed gets delivered, the RBI would have bought a staggering INR 3,36,000 crores in the current financial year. This will total to more than 80% of the net borrowing program of the central government for the current financial year.

 

There are a few important takeaways from the new OMO announcement:

 
1. This displays full continuity in RBI policy with respect to monetary policy measures. Thus it may be recalled that Dr. Patel and Acharya had continued recent history when choosing OMOs over CRR as the preferred tool for liquidity infusion. In fact, the question of CRR usage had been summarily dismissed in the post policy conference calls in December. With a change in Governor, there was an expectation in some quarters (and fear in bond market) that the tool may get discussed again. However, this stepped up pace of OMOs puts back to rest this speculation.
 
2. This re-emphasizes the commitment of RBI to achieve neutral core liquidity at the very least. Also, and somewhat unlike previously, now this is being done very proactively basis forward liquidity calculations. Dr. Acharya had laid out the liquidity objective in some detail in the December policy. Thus he had explained that RBI was guided by principle of managing system-wide liquidity. It is also the lender of last resort wherever needed, but he didn’t think that was required currently. This principle also seems to be getting preserved after the change in Governor, with possible sector level liquidity shortages potentially driving RBI to be even more proactive on system-wide liquidity.
 
3. With this quantum of OMOs, the impact of minor supply deviation on government bonds owing to small potential fiscal slippages may well get masked. To be clear and as noted before, although we think the actual run rate so far is tracking a slippage, it may still happen that no slippage is actually shown by deferring some spending items. Also, a small slippage may not necessarily translate into additional borrowing through dated securities. One can always levy a charge that the RBI is incentivizing slippages in some sense by taking out such large amounts of government bonds from the market. However, this has to be looked at as an unintended cost of policy. There is little other option, given the ask on liquidity creation and given that RBI wants to retain the current CRR levels. We aren’t too sympathetic to the idea of longer term repos. For one, CIC is an annual phenomenon and will be a drag on core liquidity next year as well. Assuming the same RBI dividend to the government, the only other offset will be if balance of payment (BoP) turns substantially positive and RBI buys those dollars and creates rupee liquidity. However, it will not be prudent to take a view on this. Also, banks may be reluctant to lend forward temporary liquidity provided to them, even if the liquidity provided is of a somewhat longer term.
 

Investor Implications

 

The current rally seems to be getting treated with suspicion by most investors. The context is understandable, since the past year has seen a rapid rise in yields and mark-to-market losses. Also, just a few months back the general wisdom of the market was to expect successive further rate hikes. Also potentially adding to suspicion is the fact that this staggering quantum of OMOs may be artificially holding down government bond yields. So this begs the question, what happens when those OMOs cease; possible at beginning of next financial year? Against these concerns, however, one should keep the following points in mind; in our view:

 
1. The 175 bps odd rise in yields between mid of 2017 to September 2018 (taking 10-year government bond as benchmark) has been matched or surpassed only twice before in the last 10 years. Both those times were exceptional. The first was 2009, when the government responded to the global financial crisis with a huge deficit expansion and consequent large scale excess borrowing. The second was 2013’s taper tantrum when India was running double digit CPI and almost 5% current account deficit. It is especially noteworthy that the current episode happened without any large macro imbalance in our system. The point is that this magnitude of volatility is a rare phenomenon and shouldn’t colour asset allocation decisions of investors.
 
2. There is a global context also to the current bond rally. As we have elaborated elsewhere, there is a case that the unsynchronized recovery theme underway for most of 2018 may be giving way to a period of synchronized slowdown. The action from commodities and yields curves, as well as variety of economic data, certainly seems to be suggesting as much. If indeed this is the case, then there is a case for fundamental shifts in asset allocation tables in favour of quality fixed income; rather than just looking at the current phase tactically. Thus the rate cycle has peaked and the RBI is already more sensitive than any time in recent history towards provisioning of adequate liquidity. If the global context remains as it lately is, then from here to explicit easing is just one step ahead.
 
3. The ‘OMO effect’ is most certainly impacting government bond yields. This is getting clearly evidenced in a large widening of AAA and SDL spread over government bonds. Thus as an example, AAA spread over corresponding government bond is around 100 bps at the 5-year point. To take another valuation metric, 5-year AAA to repo rate spread at between 175 – 200 bps is still attractively placed when compared with its 5-year history. Thus to us the choice is more of which risk – reward point to participate in rather than ignoring altogether what may just be a sustainable turn in the environment for high quality fixed income allocations.
 

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.

Tag:

Suyash Choudhary

In a surprise move, RBI Governor Dr. Urjit Patel resigned from office yesterday citing personal reasons. Needless to say, this comes as a huge surprise not only because of the gravity of the event but also owing to a view that a somewhat cordial way forward had been agreed upon in the last board meeting with respect to major points of difference between the central bank and the government. We highlight here first thoughts on implications.

 
1. This expands India’s risk premium at least in the short term. Whether this widened risk premium remains or not will importantly depend upon the way forward. Thus the simple common perception today is that there is intent to compromise the RBI’s independence in a variety of ways. The most important from a bond market perspective amongst these is the notion that the government wants large portions of RBI’s capital to step up fiscal spending. This notion and these perceptions need to be controlled. If the government is successful in doing this, then the current widening of risk premium may well prove temporary.
 
2. If one has to look for silver linings, one can feel somewhat comforted that this is happening now when oil is down and US dollar has stagnated, and not in the harsh period of July – October. At the same time there is a twinge of regret / frustration as well to see the rupee back at 72 plus even after the substantial correction in oil and general stability in global macro.
 
3. At the end of the day, from the bond market standpoint two things are critical:
 
a. The assumption that repo rate has peaked should hold: It must be remembered that there is a global context here as well. Thus the phase of unsynchronized recovery in play for most of this year, may be morphing into one of a more synchronized slowdown. Recent more dovish Fed commentary as well as part inversions to the US yield curve also point to the fact that this narrative seems to be gaining strength. Besides, growth locally seems to be losing momentum as well partly owing to tighter financial conditions. All told then, we remain confident that one needn’t change the assumption and the repo rate has indeed peaked in this cycle.
 
b. The current market expectation of abundant open market operations (OMOs) over Jan – March should remain intact: While there is nothing yet to challenge this assumption, it may get tested in the very outlier event that the ‘capital transfer from RBI’ theory proves to be true. However, one has to reiterate that the latest information in the public domain in this regard is that a committee is to be formed to assess an appropriate capital framework for the RBI. This means that the process will be structured and will get conducted over a period of time, as opposed to an ad-hoc large transfer that some are currently fearing.
 

All told then, the current bond positive framework largely remains intact. It is important to remember that there is a global context here as well which makes the theme more durable. It is now up to the government to do everything to restore the perceived dent in RBI’s independence and to compress this unfortunate widening in India risk premium that the unanticipated exit of the RBI Governor has brought about.

 

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 security may or may not continue to form part of the scheme’s portfolio in future.  Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. 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 MPC kept repo rate and stance unchanged as was widely expected, although one member voted for stance to be changed back to neutral. The RBI cut SLR to 18% at the rate of 0.25% per quarter starting January. Key highlights as follows:

 

On CPI

 

The market got the cut to CPI forecast that it was looking for. In fact, the cut was quite meaningful to 2.7 – 3.2% in H2 FY 19 (from 3.9 – 4.5% in last policy) and to 3.8 – 4.2% in H1 FY20 (4.8% for Q1 FY20 in last policy). Given these numbers one would have expected a much more dovish assessment. However, there seems to be a distinct sense of unease with respect to the durability of the fall in CPI. Thus the MPC noted that the CPI outlook is driven mainly by an unexpected softening of food inflation and collapse in oil prices in a relatively short period of time. Excluding food items, inflation has remained sticky and elevated, and the output gap remains virtually closed. In the post policy call, Governor Patel also referred to the large uncertainties in forecast and that a few more months are needed to see impact of MSP. He flagged risks of sudden reversal especially in perishables. He also noted that volatility indicators in oil have not subsided even though prices have fallen (which means that outlook on oil remains unstable). Finally, he also flagged risks to fiscal slippage as influencing inflation outlook. However, it is here also that Dr. Patel also threw in the first dovish surprise: he said something to the effect that if CPI upside doesn’t materialize, then there is possibility of space opening up for commensurate action. This has given market first hopes in a direction no one was even daring to think about: the possibility of actual monetary easing.

 

On Growth

 

There seems to be a clear assessment that global growth is slowing. However, what is somewhat surprising is that RBI still assess the local growth outlook as quite robust. So the GDP forecast is retained at 7.4%, but with risks to downside. Thus global slowdown, financial market volatility, and lower Rabi sowing is considered as risks. But on the other hand, the fall in oil is seen as a strong positive to demand. To be fair, many of the indicators that RBI monitors are still robust. This may be driving the sanguine view on growth and, by implication, output gap.  Thus the higher import growth, stable business sentiment in Q3, the strong composite PMI prints released recently, and non-food credit growing at 15% (higher than GDP) were all mentioned as supporting the growth outlook.

 

On Liquidity

 

Dr. Acharya explained that RBI was guided by principle of managing system-wide liquidity. It is also the lender of last resort wherever needed, but he didn’t think that was required currently. He defended measures undertaken to alleviate recent HFC / NBFC stress. There was a clear preference highlighted for OMOs and term repos for liquidity infusion. Dr. Acharya mentioned that long term repos will be done around advance taxes. The second dovish surprise came from him when he assessed that increased frequency of OMOs may be required till end of March. Additionally, the Governor was quite emphatic in denying any need for a CRR change.

 

Takeaways

 
On the face of it, barring the drastic CPI cuts, the policy was quite neutral. The confidence in growth seems a shade too robust, and we think there may be some downgrades here down the line. In particular, the lagged effect of recent tightening of credit to certain sectors may have been somewhat underplayed. Having said this, the market got everything it wanted. Thus it got confirmation that it was right in unwinding practically all future rate hike expectations. While it is too soon to already start thinking of easing, the statement made by Governor Patel may at least start the discussion at some point. This is especially true if CPI sticks to the forecasted path for the next few months and the current nascent concerns about global growth were to get more amplified going forward. Indeed, the global context is quite relevant here and has been one of our core pillars of fixed income view lately. In this respect, the recent mild inversion between 2 and 5 year US treasuries is inviting a lot of interest as potentially signaling market’s first tentative steps towards pricing in a slowdown ahead, and the Fed potentially making a policy mistake by continuing to hike. These are nascent trends and can easily reverse. But they definitely merit attention, coming as they do on the back of growth slowing materially in large pockets of the rest of the world and in fact the US itself showing some sector specific weaknesses lately.

 

The other important clarification provided is that OMOs are likely to continue at a similar pace in the next quarter. There was a chance that the pace would have come off in the next quarter. This was basis an expectation that the RBI will not fully plug the core liquidity deficit by end March but may be comfortable with a INR 50,000 – 75,000 crore deficit. However, it looks like that the central bank is likely to be more proactive and may attempt actual neutral core liquidity by March. This could be emanating from a consciousness that there are sector specific liquidity challenges and hence RBI needs to be even more proactive in abundantly delivering on its principle of managing system wise liquidity. This means the favorable demand supply balance for government bonds is likely to continue till fiscal end.

 

From a strategy perspective, we reiterate here our view that the rate hike cycle is over and that one has to be long on quality fixed income (sovereign / AAA). In our bond and gilt funds we have increased exposure to the 10 year point over the past month or so through a combination of government bonds, SDL, and AAA bonds. At the very least, however, one can no longer be underweight on AAA front end up to 5 years.

 

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 growth data for the September quarter surprised expectations to the downside. Thus real GVA printed 6.9% versus consensus estimates of 7.3%. Whereas, real GDP came in at 7.1% versus 7.5% expected. As the graph below shows the so-called core GVA, which strips out agriculture and government sectors and is hence considered a proxy for the private sector, has slowed as well.

 
graph1_2617

 

This slowdown is consistent with the core anchor for our fixed income view that peak growth is past us. To recall, this view is based largely around two pillars: 1> the world has exited the period of synchronized recovery that it saw over most of the past two years and is now marked by a slowing trade cycle; 2> the progressive tightening in financial conditions for most of the current year is bound to have a lagged impact on growth. That said, the slowdown already in official GVA is somewhat more pronounced than what one may have expected. This alongside substantial undershoots in CPI as well as a dramatic recent fall in oil prices reaffirms our view that there are no more repo rate hikes in the current cycle.

 

The weakest link in our macro in our view continues to be fiscal. In that regard, the recently released data for October doesn’t provide much comfort. Not only have we breached the 100% targeted fiscal deficit by October, but as the chart below shows, we are now tracking a higher run rate on fiscal deficit versus target, than we were at the same time last year. Thus year to date deficit till October is 104% of target versus 96% last year. This is particularly disconcerting since last year we ended up breaching the deficit target by 0.3% (which is why the bar for March below is shown at greater than 100%).

 
graph1_2617

 
Against these numbers, however, are continued assurances from the highest levels of the finance ministry that the budget targets will be met. The commentary so far suggests this may be done through higher collections on direct taxes, possible overshoot on disinvestment, normal spending cuts as some ministries are unable to spend budgeted amounts, and rolling over of some excess subsidy items. There is no talk yet of voluntarily curbing discretionary (largely capital) spending. Should it come to this eventually, this may be an additional headwind to incremental growth. Conversely, as growth slows the temptation to show some small deficit breach may be higher. As of now the view remains that deficit targets will be met on paper. But this remains an area one has to watch carefully.

 

Finally, the RBI revealed its preference for continued Open Market Operations (OMO) purchases as its dominant liquidity infusion tool. Thus over and above the INR 1,26,000 crores done till late November, it announced another INR 50,000 crores till end of December (INR 10,000 crores done in last week of November and the balance scheduled for December). This is consistent with our view and given core liquidity calculations we fully expect more to happen over January – March as well.

 

Way Forward
 

There are certain offsets that need monitoring with respect to some of the trends mentioned above. The biggest one is a possible turn in the US dollar. Thus with tentative signs of some loss in economic data momentum as well as some turn in Fed commentary, there is already expectation building that the best of dollar bull run may be behind us. This may not show as much in the commonly tracked dollar index given that the Euro is suffering its own ills. However, what matters more is what dollar does versus other major pairs. In particular, the Indian rupee stands to gain both from this potential turn as well as from the dramatic fall in crude prices; just as it was suffering earlier in the year from the double whammy of stronger dollar as well as higher oil prices. Rupee has already appreciated around 6% from its October lows. Should this continue, this will constitute as a major source of incrementally easing the recently tight financial conditions. It will also constitute an additional source of liquidity creation and to that extent reduce reliance on OMOs alone.

 

Some observations on oil prices are also in order. At the time of writing, there has been some rebound in oil prices owing to US and China potentially de-escalating their mutual trade tension somewhat, and on news that Russia and Saudi have arrived at some tentative agreements to curb oil output. It is to be noted that after a spectacular 30% fall in a matter of less than two months, some rebound should be fully expected in crude prices. What matters more for our macros is that oil sustains in a lower range for longer. As an example if, alongside a stable rupee, Brent stabilizes even in the USD 65 – 70 per barrel mark, we will start seeing the macro benefits of this in current account and Consumer Price Index (CPI) down the line.

 

From a strategy standpoint, the view remains positive on AAA / sovereign. While rates have rallied meaningfully from the top, the macro situation is now much more positive. With no further hikes expected in the repo rate and assuming a stable currency and commodity outlook, we believe valuations on AAA / sovereign are still quite attractive.

 

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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