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Investment Insights

Suyash Choudhary

The Monetary Policy Committee (MPC) has now delivered a second successive rate cut in the current calendar year. But a bystander only observing the bond and money markets may have been excused in believing that the second cut was actually no cut at all, or indeed maybe even a hike! Thus yields have risen across the board since the April rate cut. The quantum of rise has been between 25 – 50 bps in money market and front end bond yields. This reversal is partly owing to the fact that market positions were heavy going into the policy with participants hoping for an explicit or implicit signaling of change in stance alongside the rate cut. However, even adjusting for this forced recalibration of market positions, it is evident that the market is not transmitting rate cuts. It is thus unreasonable to expect the banking system to do so. The endeavor in this note is to evaluate certain aspects of current monetary policy in light of efficacy of transmission to the bond and money markets.

 

The Importance of Guidance

 

It can be argued that the MPC is under-utilizing guidance as a policy tool. One of the enablers for transmission is for market agents to believe in directional continuity in policy for some time. However, in the current framework rate cuts are being administered from a neutral stance. While this ‘hedges’ the MPC and allows flexibility to be data dependent and move in either direction, it also tends to impart a ‘one and done’ kind of impression to market. When the environment is extremely uncertain this kind of an approach may make sense. However, Consumer Price Index (CPI) has now averaged below 4% for the past 2 successive financial years. Also if RBI forecasts come true, it is not likely to be much higher in the visible future as well. It is quite curious then why the stance is still assessed to be neutral. Put another way, does this projection not deserve at least a commitment not to hike from MPC? One probable reason for the reticence could be continued lack of confidence with respect to forecasting the target variable. This may in turn have to do with the target framework being flawed itself. This is discussed in greater detail below.

 

A Target Variable That One Can Work With

 

It is apparent that a food heavy variable is fundamentally difficult to target by monetary policy. An additional complication for a system like India’s is the presence of a large alternate financing market where transmission of monetary policy may be particularly muted. Thus the appropriateness of the target variable can well be disputed. However, that is a subject often debated and is not the scope of assessment here. Rather a case can be made that under a flexible inflation targeting mandate the MPC is rigidly targeting a point (4%) in a variable that it has inherently little control on. It is probably a happy coincidence that food inflation started to stabilize and then fall around the same time as the RBI de-facto adopted some sort of a CPI targeting framework (although the mandate was formalized later). Put another way, the issues around the ability to target our CPI via monetary policy have probably not been tested so far. It is to be clarified that the difficulty to target here is being considered only from the view point that the loss of output embedded in bringing down CPI via monetary policy may be much higher, since a large part of CPI may have muted direct response to monetary policy changes.

 

Given this, and within the constraints of flexible inflation targeting, it may be prudent to evolve a framework in which RBI / MPC have more control over the target variable. As an example, some sort of a real rate framework would be helpful. This will essentially have 2 components: 1> the nominal rate to be used (repo, 1 year treasury bill etc). 2> forecasted average CPI (1 year ahead, for instance). A start was made under the Rajan era but it was half hearted at best and was never seriously pursued. Once these 2 components are defined and frozen, an indicative real rate target range can be devised basis risks to the inflation target. This will also take into account the state of economic growth. Such a framework will still be based on CPI targeting but will make the direct target variable (the real positive rate range) more controllable by monetary policy. It will also potentially remove some uncertainty in forecasted reaction function of the MPC, especially insofar as uncertainties relate to responses to potential near term supply side risks.

 

As an example, the state of monsoon is a perpetual factor in monetary policy considerations. But it may be argued that even if a bad monsoon constitutes a short term supply side shock to food prices, if the underlying context is that of weak demand, it may not percolate into second round effects. Thus while near term CPI may rise the medium term forecast for CPI may not move materially and hence, under a well defined real rate framework,  may be immaterial from a monetary policy standpoint. The framework would require the RBI to more carefully refine its medium term CPI forecasts and, importantly, would refocus attention to the leads and lags in monetary policy. Importantly also, although this discussion is not relevant in the current context, should owing to government policies CPI threaten to rise substantially, RBI / MPC can recalibrate the target band for real interest rates higher to reassure market agents about the seriousness to ensure financial stability. By contrast in the current interpretation of the CPI targeting framework, a sustained substantial breach of 4% may pose a narrative challenge for the RBI / MPC. For market participants, it may pose an interpretation challenge on what reaction to now expect from policy.

 

In summary, monetary policy may never be comfortable targeting a difficult to target policy variable which is substantially subject to short term supply shocks. Hence it may always tend to have hawkish qualifiers which may in turn impede market transmission. An alternate framework around the same target variable, such as the one proposed above, may partly address this constraint.

 

The Stance on Liquidity

 

This is probably the most hotly debated topic with respect to our monetary policy. There is a view that the when rates are being cut, liquidity should be kept in marginally positive territory. Whereas, the preference from the central bank continues to be to keep liquidity in deficit. In some sense this also reaffirms the bias towards ‘low involvement ‘ easing, with consequent information for market agents that impedes market transmission. For instance  a 3 month bank CD rate is almost 125 bps over the repo rate currently. While lack of transmission at the longer end may be linked to the fiscal, stickier money market rates should be of immediate concern to a central bank so focused on transmission. This was one of the apparent reasons for Rajan to review liquidity stance in early 2016 when RBI moved to targeting neutral liquidity from 1%  of NDLT deficit previously.

 

Conclusion

 

It is true that there are various aspects that are impeding monetary transmission, many of which are outside of the RBI / MPC influence. These include fiscal as well as elevated administered rates in the system. Transmission in banks lending rates may also depend upon risk perceptions. However, the discussion here has only been from the market’s standpoint and in a backdrop of even front end bond and money market rates not transmitting policy rate cuts. Also it has only focused on issues that are within the remit of RBI / MPC. A sharper focus on guidance, an enhancement to CPI targeting by introducing a standardized real rate target band that itself responds to evolving risks to medium term inflation forecasts, and a review of stance on liquidity that specifically also accounts for money market rates should all facilitate transmission at least from the fixed income market. These can be supplemented by other measures like for instance the dollar rupee swap that the RBI has recently done that, apart from creating rupee liquidity, also brings down forward hedge costs. Another potential idea could be to allow systematically important AAA Government of India owned / serviced entity corporate bonds to become eligible for borrowing from liquidity adjustment facility (LAF) window of the RBI.

 

In our view, it is reasonable to expect discussion on some of these going forward. The focus seems to be now on transmission and there is possibility that this is studied under a more practical lens by the new governor. One doesn’t rule out internal resistances, especially as the assessment on growth itself seems to be divergent amongst RBI members. Also both the official current GDP as well as the forecasted mild acceleration may not be sitting well with the information being provided by more concurrent real world indicators. Nevertheless, barring a global adverse shock or a post election domestic policy fiscal  and / or reflationary shock, we expect some movement to facilitate greater transmission in the months ahead. This may indeed be a bigger trigger for the bond market as well rather than one more low involvement, neutrally delivered rate cut.

 

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 Monetary Policy Committee (MPC) decided to cut repo rate by 25 bps (4:2 majority) while keeping stance neutral (5:1 majority). The Reserve Bank of India (RBI) has cut both its growth and inflation forecast as well. Prima facie there is nothing to complain in this policy. However, this is somewhat of a disappointment versus market expectations. Although officially expecting ‘only’ 25 bps cut, participants were hoping for a simultaneous change in stance as well. An additional near term drag has been the decision to allow another 2% of SLR as level 1 high quality liquid assets (HQLAs) for the purpose of calculating liquidity coverage ratio (LCR). Ceteris paribus this is a disincentive for running excess Statutory Liquidity Ratio (SLR) to this extent, although the implementation being in stages may blunt this disincentive. Below are some of our key takeaways from the policy:

 
1. Growth: The assessment on the global economy is that there has been further loss of pace in economic activity and that the slowdown is more synchronized. The assessment on India also doesn’t sound particularly robust. High frequency indicators in manufacturing are ‘sluggish’ whereas in the services sector they suggest ‘significant moderation in activity’. Credit flow has improved for large industries but remains tepid for micro, small, and medium enterprises. Export growth is weak, while non-oil non-gold imports have declined sharply. The stand out contrary data point here is that as per the RBI’s order book, inventory and capacity utilization survey (OBICUS), capacity utilization has improved to 75.9% in Q3 from 74.8% in Q2, exceeding its long term average. All told, GDP growth forecast for FY 20 has been cut to 7.2% with risks evenly balanced.
 
2. Inflation: While food inflation is recovering somewhat, fuels group inflation has collapsed further. Core Consumer Price Index (CPI) has bounced around with mixed changes in underlying components. Notably, inflation expectations as per RBI’s survey of households have fallen 40 bps further for each of the 3 months ahead and 1 year ahead horizons. It may be remembered that in the previous round, expectations for 3 months had softened by 80 bps and 1 year by 130 bps. Thus all told this constitutes a reasonable softening of expectations since December. Additionally, input and output price expectations of producers in RBI’s surveys have also moderated further. All told, CPI projections have been revised further lower, to 2.4% in Q4 FY19, 2.9 – 3% in H1 FY 20 and 3.5 – 3.8% in H2 FY 20, with risks broadly balanced. Importantly, forecast for Q4 FY 20 at 3.8% is still below the mid-point of RBI’s target range. The accompanying monetary policy report (MPR) pegs Q4 FY 21 estimate at 4.1%. For FY 21 structural models indicate inflation will move in a range of 3.8 – 4.1%, assuming a normal monsoon and no major exogenous or policy shocks.
 

Finally, the assessment ends with a very emphatic statement: “The MPC notes that the output gap remains negative and the domestic economy is facing headwinds, especially on the global front. The need is to strengthen domestic growth impulses by spurring private investment which has remained sluggish.”

 

Takeaways

 

As discussed above, the market has been somewhat underwhelmed by action versus its own expectations. When pushed about further rate action or the possibility of considering minor positive liquidity in order to facilitate transmission, the governor remained completely non-committal in the post policy meet. This is to be expected since the current action summarizes the sum total of all current deliberations and the governor is in no position to unilaterally commit to further action. However, it also served to pour near term cold water on market’s ‘blue sky’ expectations.

 

On the face of it, market is right to feel somewhat underwhelmed. As per RBI’s assessment CPI will average 3.3% in FY 20 and around 4% in FY21, assuming a normal monsoon and no major exogenous or policy shocks. It is to be remembered that this is on the back of FY18 and FY19 already at below 4% average CPI. Given this, one may be justified in questioning the lack of more emphatic action. If policy is being held back on account of less confidence on predictability, then it is the models that need more work. If it is on fears of shocks like monsoon, then the framework itself needs revisiting. This is because monsoons are an annual phenomenon. More importantly, they constitute a supply shock and so long as there is no second round effect from this, they should be looked through. It is also possible that even though risks to CPI are stated as being balanced, RBI members privately think that they are skewed to the upside. The other curiosity is with respect to the growth forecast. Despite downbeat current assessment on local and global prospects, the RBI expects growth to accelerate from 7% in FY 19, to 7.2% in FY 20, to 7.4% in FY 21. This very sanguine forecast may also be contributing to the lack of urgency to act more decisively even with CPI being very well behaved. Notably, the forecasted acceleration is despite the forecasted slowdown in global growth by international agencies, also quoted by RBI. Our most likely inference here is that the RBI’s reaction function has indeed turned more emphatic under the new governor and this will continue to get further revealed in the months to come.

 

From a bond market standpoint, there is some near term disappointment to contend with given the expectations going into the event. However, given the global and local backdrop we expect the adverse reaction to be largely contained. Specifically, we expect there is more easing in the pipeline. The introduction of the forex swap tool for liquidity has had a very benign effect on short end rates, given that it has caused hedge costs to fall by around 100 bps. The spread between 4 – 5 year corporate bonds to 10 year has now risen to almost 70 bps. This may be a large reason why the 10 year may also tend to find anchor. Our preference remains for spread assets like SDL and AAA corporate at the 10 year point. Spreads versus underlying government bonds have shrunk versus what they were in early March and we believe there may be more room to go given the underlying environment and policy thrust on transmission.
 
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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