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Suyash Choudhary

The Monetary Policy Committee (MPC) delivered a unanimous 25 bps rate cut as well a change in stance to accommodative. CPI forecast has been marginally revised upwards for H1 FY 20 to 3 – 3.1% (2.9 – 3% earlier), but is a shade lower for H2 at 3.4 – 3.7% (3.5 – 3.8% earlier). The commentary notes upside pressure to food prices but a broad based decline in core inflation on the back of ‘significant’ weakening of demand conditions. Crude prices are volatile but near term inflation expectations of households have continued to moderate. Acknowledging slowdown in growth drivers Gross Domestic Product (GDP) forecast is revised lower to 6.4 – 6.7% in H1 (6.8 – 7.1% earlier) and 7.2 – 7.5% in H2 (7.3 – 7.4%). The MPC notes that “growth impulses have weakened significantly as reflected in a further widening of the output gap compared to the April 2019 policy”.

 

We had discussed in a recent note (please refer https://www.idfcmf.com/insights/transmission-impossible-a-discussion-on-monetary-policy/ ) three items that monetary policy could have addressed in order to improve transmission. These were 1> better utilization of the guidance tool in terms of changing stance 2> redrafting the Consumer Price Index (CPI) target framework to make it more targetable by, as an example, linking it to a real rate framework. 3> revisiting the stance on liquidity. We are happy to note that with the policy today and in the run up to it, two out of these three have been largely adopted. Thus the stance has been made explicitly accommodative. In our view it has been a misinterpretation to view a change in stance to be unnecessary this late in the cycle. Rather it was an underutilization of a potent  policy tool that has now been rectified. The RBI seems to also have de-facto adopted a positive liquidity stance. This is evident in core liquidity having been turned positive some time back and yet the RBI having persisted with further injection tools including an OMO that is scheduled for mid June. Now with government spending happening, the headline liquidity is positive too. Further, an internal  working group has been  constituted to review comprehensively the existing liquidity management framework and suggest measures, among others, to (i) simplify the current liquidity management framework; and (ii) clearly communicate the objectives, quantitative measures and toolkit of liquidity management by the Reserve Bank. The Group is expected to submit its report by mid-July 2019.

 

The one aspect that we have been disappointed with is the continued insistence not to anchor monetary policy to some sort of a better defined real rate framework. The Governor was emphatic in saying that observers will have to deduce this via RBI /MPC actions and that he would not commit to anything on this point. However, so long as the absence of this framework doesn’t impart a systematic hawkish bias to policy (as seems to have been the case in the past), this may not be a constraint at least in the near term.

 

The other notable aspects of the press conference post policy are as follows:

 
1. The Governor seems to have a reasonably benign view on government finances. Thus he underplayed the recent stress instead focusing on the consolidation underway over the past few years. Furthermore, he also doesn’t seem to be unduly concerned about PSU borrowings saying that borrowings done by PSUs who have own revenue streams shouldn’t be looked upon as government borrowing. This is somewhat surprising since the common perception is that at least some part of the heavier than usual PSU borrowings recently has been to compensate for lack of budget resource availability. Similarly the heavier usage of small savings was similarly not considered to be a very sticky point.
 
2. Given very large buffer stocks (3.4 times prescribed norm), there seems to be less of a concern from an inflation perspective, in case monsoons turn out to be weaker. This is the right approach and in fact we have argued one step further to say that even if prices were to rise on the back of a supply shock, they are unlikely to have second round effects and hence are unlikely to be relevant from a monetary policy standpoint.
 
3. A welcome clarification has been provided with respect to state development loans (SDL) with the Governor explicitly stating that they have implicit sovereign guarantee and that the RBI automatically debits state accounts at time of payment. This is relevant since a recent push by RBI towards asking states to get rated was somewhat muddying the risk perception, since a question could always be asked as to what the importance of rating was for a sovereign backed asset? The clarification now provided conclusively clears the air.

 

Implications

 

World growth expectations have taken a decided turn towards the worse over the past month or so. This is now reflected in expectations of easing by major central banks later in the year. As an example, the US yield curve is now reasonably inverted upto 10 years with market expecting 2 – 3 rate cuts in the future. Locally as well there has been a  marked deterioration in growth drivers with consumption being the latest casualty, probably courtesy an impact to leverage given the ongoing stresses in certain parts of the financing market. Thus the current monetary easing underway has to be looked at in this overall context. While currently the expectation would be for one last rate cut alongside continued easy liquidity, this can very quickly change towards expecting a deeper further easing should the global outlook further deteriorate.

 

The next major domestic trigger is going to be the Union Budget in early July. Given the large undershoots in the actual revenue collections in FY 19 versus even the revised numbers presented in February, the numbers targeted in the interim budget are looking truly daunting. This is especially in context of the ongoing growth slowdown. Thus the new finance minister will have a tall task to present a credible budget while sticking to the assumed deficit target. In this context the Jalan committee’s report on potential excess RBI reserves and their usage by the government will assume importance.

 

From a bond market standpoint, the focus should remain on quality rates (sovereign, SDL, AAA) as the best vehicles to play the current macro environment. As developments continually highlight, the lower rated credit markets are far from settled and the spreads that can effectively be captured there may not yet be compensating for the risks involved.

 

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 elections handing over a continued strong stable government is welcome relief to market participants. In particular, it will help keep India’s country risk premium stable amongst its peers. With this out of the way, local policy can afford to start focusing emphatically on the evolving macro narrative. This is marked by a synchronized global slowdown which has been underway since late last year and has caused major central banks to start leaning dovish since early this year. Moreover, India’s own growth and inflation dynamics remain soft as well. The Monetary Policy Committee (MPC) has so far responded with two rate cuts, but there is little that has been achieved by way of transmission.

 

The following recent developments are noteworthy:

 
1. While the domestic auto sector has been showing a significant slowdown for some time, there is now a sense of the consumption slowdown spreading more generally as well.
 
2. The credit aversion in parts of the financial system that seemed to be stabilizing earlier in the year seems to have been aggravated again recently.
 
3. The global narrative on growth which was beginning to look somewhat optimistic again post the US Fed pivot and recent Chinese expansion of credit has turned murky once more with hopes around a US – China deal having been disappointed for now.;
 
The Government’s Constraints

 

There is little doubt then that India, alongside most of the world, is in the midst of a cyclical slowdown. It is noteworthy that this slowdown is despite the fiscal ‘expansion’ that has happened over the past year or so. Most of this expansion seems to have happened almost involuntarily as revenues on GST have meaningfully undershot expectations. Furthermore, with the likely undershooting of FY19 tax revenue numbers from even the revised estimates in the budget, the year on year growth rates implied in the FY 20 interim budget numbers look very aggressive.

 

It is clear then that there is very little room for the government to step up spending in any meaningful manner in the immediate future ahead. In fact in the interest of credibility it would be prudent for the government to restate the fiscal deficit taking into account the actual revenue outcomes for this year and the substantial usage of below the line items in financing the budget. It is to be clarified that some deployment of counter-cyclical fiscal expansion given the macro narrative wouldn’t be amiss at all. However, the incremental room as discussed here is limited. More importantly, the bond supply associated with this level of deficit is leading to genuine crowding out and elevated nominal bond yields despite very low inflation. Thus, there is a macro impact of elevated long term real yields that needs to be taken into account when thinking about an incremental fiscal stimulus. Some avenue for extra spending may come about if the government gets a significant transfer of capital from RBI. The government may also focus on more substantial monetization of its assets in order to increase spending without appreciably breaching a fiscal consolidation framework. Ultimately, however, true fiscal flexibility will have to wait till recent tax reforms bear fruits respecting the so-called ‘J’ curve, especially in the case of GST.

 

Player One: The RBI

 

The maximum ‘room’ as it were resides with monetary policy currently, in our view. Consumer Price Index (CPI) has tracked lower than the mid-point of the official target band for a while now. Furthermore, it is likely to remain relatively benign in the foreseeable future as well, even accounting for some upside to the RBI’s assessment for the year ahead. Major global central banks have turned dovish on the margin.  Our election verdict will serve to possibly compress India specific risks somewhat versus other similar emerging markets. The local growth narrative is one of a visible slowdown. Various sectors like real estate and telecom remain relatively stressed and income growth remains muted. Sections of the financing market are clogged and may have served to prematurely impact the consumer leverage cycle which, in the absence of any significant upturn in incomes, is possibly what is visible now in slowing consumer demand. In short, in the real world it is difficult to worry about demand side inflation at least in the near term. Despite this scenario, real rates remain high even at the short end and policy stance remains neutral. Also even though core liquidity has turned positive for now, the RBI’s stance on it remains unclear to market participants.

 

We had highlighted in a recent note (https://www.idfcmf.com/insights/transmission-impossible-a-discussion-on-monetary-policy/) 3 areas where, in our view, there is scope for RBI (and to some extent MPC) to more fully examine and utilize the tools available. Drawing from this framework, we think it is desirable for the MPC to shift monetary policy stance to accommodative. Furthermore, from an RBI standpoint, an indeterminate stance on liquidity (though backed over the past few months with stepped up efforts at liquidity creation) may no longer be enough. Market participants need to be assured of sustained positive liquidity for near term spreads to come down. The situation in some sense is similar to 2016 where Rajan had reacted by officially clarifying in the April 2016 monetary policy review to “continue to provide liquidity as required but progressively lower the average ex ante liquidity deficit in the system from one per cent of NDTL to a position closer to neutrality”. In our view, the time may be opportune to similarly officially state in the monetary policy review the intent to move liquidity to some sort of surplus (say, 0.5 or 1 % of NDTL). The shift in stance combined with this stated intent of affirmative action on liquidity may go a long way in improving transmission at least so far as the money market curve is concerned. Also given the very narrow policy corridor now, such a move cannot be interpreted as ‘back door’ policy easing by any stretch of the imagination.

 

The Objections to Monetary Easing (And Why We Don’t Agree With Them)

 

Two objections that are sometimes made to additional monetary easing are as follows:

 
1. It won’t matter to the NBFC issue:  There are two aspects to the problem currently. One, near term spreads are extremely volatile and generally elevated. Two, the credit spread over the risk free has widened significantly for a section of the market. To be clear, any change to liquidity stance is only aimed at addressing the first issue. As an example, spread of 3 month bank CD to repo rate had recently widened to almost 125 bps over the repo rate, despite it not being busy season any more. It has fallen since largely on market’s expectation of further monetary easing. This can be anchored more sustainably with the change in liquidity stance. The credit spread issue will work out over longer periods of time as balance sheet issues get addressed and risk perceptions stabilize. Unless there is a system destabilization risk (which doesn’t seem to be the case currently), there is little role for RBI here without inviting a moral hazard problem.
 
2. The previous stimulus of 2009 ended badly: The 2009 stimulus was of an extraordinary degree across fiscal and monetary policy, and wasn’t pulled back even when it was clear that the economy no longer needed it. The lesson is, of course, relevant. However, it is a stretch to not act now for fear of this repeating. The government has largely adhered to a fiscal consolidation framework despite pay commission pressures in the past few years. Challenges have recently surfaced mostly owing to GST disappointment but by no means are stability threatening. On its part the RBI/MPC are committed to a CPI targeting framework now and will presumably counterbalance any stimulus should CPI targets look sustainably under threat in the future.
 

Conclusion

 

The election mandate of a continued strong government  will help contain sovereign risk premium and allow policy to focus on the local narrative of slowing growth. The government seems to have little fiscal space given recent pressures and must balance incremental deficit expansion with the economy-wide cost of higher real long term rates. The RBI/MPC, on the other hand, have more room and should respond now with a more decisive focus on the guidance tool for both rates and liquidity. This, in our, view has the maximum chance to influence transmission. The view remains bullish on quality bonds (sovereign, SDL, AAA) and cautious on lower rated credit.

 

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) 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.

Tag:

Suyash Choudhary

We had observed in February as to how global policy seemed to be shifting, responding to the synchronized slowdown narrative on global growth (https://www.idfcmf.com/insights/policy-puts-start-re-emerging/). With the European Central Bank (ECB) and US Federal Reserve (Fed) policy meetings since then, these initial ‘put’ options have now been significantly strengthened. Both these central banks ended up sounding much more emphatically dovish than was expected. The ECB downgraded growth and inflation forecasts, committed to keeping interest rates unchanged at least through the end of 2019, and launched a new series of quarterly targeted longer-term refinancing operations (TLTRO-III), starting in September 2019 and ending in March 2021, each with a maturity of two years.

 

The template was similar for the Fed where growth, employment and inflation projections were also downgraded. The collective assessment of members suggests no further rate hikes in the current year and just one more in 2020. To put this in perspective, the collective forecast as recently as in December was for two additional hikes in 2019, and one more in 2020. Further the Fed will start slowing the pace of balance sheet run offs from May and cease reductions in balance sheet altogether at the end of September 2019. With this the Fed has managed to throw a dovish surprise to markets in its second successive meeting. There is a view that perhaps it has been a shade too quick in locking itself into this new dovish stance, especially as the outlook on the economy still remains relatively robust and the theme rather is that an above trend growth is converging towards trend.

 

Our best guess is that this turn in the Fed is rooted in evolving inflation expectations. A hint towards this was given by the Fed Chair in his post policy conference where he seemed to suggest that even after almost 10 years of economic recovery inflation expectations have remained relatively muted. We include below a quote by Chair Powell from the most recent post policy press conference:

 

“It’s one of the major challenges of our time, really, to have inflation, you know, downward pressure on inflation let’s say. It gives central banks less room to, you know, to respond to downturns, right. So, if inflation expectations are below two percent, they’re always going to be pulling inflation down, and we’re going to be paddling upstream and trying to, you know, keep inflation at two percent, which gives us some room to cut, you know, when it’s time to cut rates when the economy weakens. And, you know, that’s something that central banks face all over the world, and we certainly face that problem too. It’s one of the, one of the things we’re looking into is part of our strategic monetary policy review this year. The proximity to the zero lower bound calls for more creative thinking about ways we can, you know, uphold the credibility of our inflation target, and you know, we’re open-minded about ways we can do that.”
 
(Source: https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20190320.pdf)

 

U.S. consumers’ inflation expectations

 

graph1_2617

 

The graph above charts various measures of consumer inflation expectations over longer periods of time. What is noteworthy is the recent dip in expectations despite the US economy having grown substantially above trend only last year. This, then, seems to us as the most telling reason behind the Fed’s remarkable policy U turn. More generally, and as also gleaned from the comments above, developed market (DM) central banks are only too aware that their policy toolkits are asymmetric: there is much more scope to address an upturn in inflation / growth versus a downturn.

 

U.S. yield curve
 

graph1_2617

 

The second graph charts the evolution of the US yield curve over the past year. As can be seen, there has been a remarkable flattening of the curve with parts of the curve now being inverted for the past few months. While the significance of curve inversions continues to get debated, it is definitely a market signal that the Fed may have found difficult to ignore as well.

 

Finally, recognition of a synchronized slowdown may very well herald a renewed phase of competitive currency depreciation. It is to be noted that this is never explicitly acknowledged by most central banks. Rather, a relatively strengthening currency feeds into policy decision making via a relative tightening of financial conditions. So far with the Fed actually hiking into a strengthening economy, a strengthening US dollar was an outcome it may have been happy to accept. Indeed, the whole point of hiking rates and running off the balance sheet would have been to net tighten financial conditions. However, this may no longer be the case going forward. Thus the Fed turn may also partly be owing to a desire to not allow financial conditions to net tighten going forward.

 

Implications

 

Major DM central banks turning dovish has green-lighted renewed robust investor allocations to emerging markets (EMs). This also provides EM central banks room to turn more accommodative without worrying about currency pressures. This being the backdrop, India itself has a soft growth – inflation set up for now and a new governor who seems to have a much stronger reaction function. This makes for a continued bullish signal for quality bonds.

 

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

RBI Expands Liquidity Tools..

By: Suyash Choudhary

The RBI has announced a new tool for liquidity creation and decided to inject rupee liquidity for 3 years through long-term foreign exchange Buy/Sell swap. Under this, the RBI will buy up to USD 5 billion from the market via auction on 26th March, and simultaneous sell it back to the same counterparties effective March 2022. Whatever amount of dollars get mopped up via these operations will reflect in RBI’s foreign exchange reserves for the tenor of the swap while also reflecting in RBI’s forward liabilities. Meanwhile, the system gets rupee equivalent liquidity for the same amount and for the same duration.

 

Given the novelty of the tool and the unexpected announcement, market interpretation of this is still fluid. The first movers are a fall in USD/INR forward premium as well as a reasonable rally in front end corporate bonds. A lower hedge cost should incrementally incentivize off shore flow into Indian ‘carry’ assets (corporate bonds chiefly). The imponderable still is whether the system will be able to tender the whole USD 5 billion in the current auction. An underlying context, however, is the recent revival in dollar flows from portfolio investors also augmented by hopes of one time purchases under the domestic stressed asset resolution process. Also, once the tool is introduced, it is quite likely that the RBI follows this up with further such auctions. If so, then cost of hedge may remain better anchored for the longer term thus making rupee assets that much more attractive. A first reaction of the move also is that the new tool implies that many fewer OMOs. This means that the steepening tendency of the yield curve that has been in play for most of this calendar year persists for now.

 

From a more medium term perspective, this may also imply that the RBI is stepping up efforts for transmission. This move, although unconnected, comes close on the heels of the country’s largest public sector bank linking its rates on savings deposits as well as on cash credit lines to the repo rate. That move has also been hailed as a significant step in the direction of ensuring better transmission of monetary policy. If RBI has indeed stepped up efforts in this direction, it is very consistent with our expectations from the new Governor. We had outlined in a recent note our assessment that monetary policy has turned more emphatic under Mr. Das and that it was possible to envisage the central bank turning even more proactive on liquidity. We had also concluded that this seemed the right approach for now given the global backdrop and the muted local growth-inflation mix (https://www.idfcmf.com/insights/policy-puts-start-re-emerging/).

 

We have been continuously flagging that 2 – 5 year AAA corporate bonds offer the best risk-reward on the yield curve.  This move further enhances their appeal on the margin. Investors should ensure that they don’t get so side-tracked by the worries in the credit market that they miss out on the clear opportunities in the quality part of the fixed income market.

 

Disclaimer:
 
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
 
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the 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

Global Policy Is Shifting, Responding To Slowing Growth

 

A lot has changed in the world over the past few months. A theme we have focused on is the changing narrative on growth which has gone from a synchronized recovery till late 2017 to significant growth divergences over most of 2018 to a synchronized slowdown since late 2018. A relatively more recent development is around policy responses to this slowdown. The starkest turn there is from the policy maker that matters the most to the world; the US Fed. From a place of forecasting multiple further rate hikes and keeping its balance sheet run down on ‘auto pilot’, the Fed has come a long way in a matter of months. For one it has turned ‘patient’ on rates. Two, balance sheet run offs are expected to end sometime late this year. Three, the Fed is in the process of discussions and debate around policy tools available to it for the next downturn. Notable amongst the discussions around this is a perspective that the Fed should allow inflation to overshoot its target at points in an economic cycle to make up for substantial periods of undershoots at other points, so that average inflation is maintained at target for the entire cycle. These debates will also add fuel to market expectations with respect to the Fed especially as growth slows and inflation continues to undershoot target.

 

China policy seems to have also turned with liquidity creation by the central bank and targeted credit getting stepped up, while the official narrative remains that they won’t go overboard with incremental credit. Indeed, given their overall debt to GDP ratios as also the fact that they only three years back had undertaken a substantial stimulus, there may actually only be limited room to again backstop growth. Finally, the European Central Bank (ECB) also seems to lately be getting perturbed by weaker growth over the past few months and may also soon undertake further rounds of long term lending operations.

 

With these developments, the risk that policy makers are ‘asleep on the wheel’ while growth deteriorates is significantly lesser. This is positive for emerging market (EM) currencies insofar that on the margin the risk of a disruptive downturn to growth leading to safe haven bids for the dollar is lesser. However, the pace of policy puts and their incremental efficacy in actually changing the momentum on growth in the near term is questionable. If at all, the incremental impact on growth data may only be visible around the latter part of the current year.

 

The Indian Perspective

 

India itself is struggling with growth drivers, after trying for some rebound early in 2018. There are two specific channels that are incrementally affecting our growth prospects. The first obviously is the international situation. Thus even though our trade dependence may be somewhat smaller, we are by no means immune to a global slowdown. The second reason is largely domestic. Financial conditions are significantly tight with some notable underlying aspects. A part of the economy as represented by housing finance companies (HFCs) and non-bank finance companies (NBFCs) has absorbed a significant chunk of incremental funds flow over the past few years. This is evident in bank credit to this sector, capital market raising, as well as growth in their own balance sheets. Parts of this sector are suddenly faced with a risk perception deterioration leading to a spike in incremental borrowing cost as well as constrained fund availability. This has obvious implications for some underlying areas especially real estate. The other more general point is that falling inflation hasn’t been commensurate with falling interest rates thus leading to a generalized real rate shock for the economy. This is happening largely owing to the fact that general government and public sector (PSU)company borrowings are causing severe excess supply pressures in the bond market. Thus the bond market is largely shut for non-government borrowers and even for PSU entities 10-year money is available today only in excess of 8.5%. Given a nominal GDP growth rate of around 11%, this creates a huge disincentive for an average economic entity to borrow for discretionary reasons. The government seems powerless in the near term to rectify this since a notable aspect of fiscal policy is the slide in indirect tax collection owing to GST still to stabilize and given the generalized slowdown. On GST, rate rationalization has been underway despite the underlying momentum not having stabilized yet thereby leading to further revenue losses. The hope here is for a ‘J’ curve effect on GST, which will down the line open up fiscal space for the government.

 

Monetary policy has potentially turned more decisive under the new Governor. He seems to be conclusively focused on growth given the RBI’s overall assessment that CPI is well contained around 4% or below for the foreseeable future. This seems the right approach for now in light of the significant challenges to local growth and the benign global backdrop provided by emerging global policy ‘puts’. Thus fears in some quarters that this is an undesirable change in policy direction are unwarranted, in our view. The test will come when the set up changes at some point in the future: for instance, if the phase of current benign global growth and dovish central banks changes.  That is when one will have to see whether RBI proves to be an adequate guardian for India’s macro stability. For now emphatic action may well be warranted and apart from rate cuts it is possible to envisage the central bank turning even more proactive on liquidity, especially if the growth – inflation mix remains as it is currently and the global backdrop remains sanguine.

 

Fixed Income Strategy

 

A benign global backdrop with an emphatic RBI Governor is ordinarily a bullish recipe for bonds. Certainly front end AAA corporate bonds between 2-  5 years are best placed in terms of risk versus reward to play this environment. The duration part of the curve has frustrated lately as the yield curve has incessantly steepened with market fearing supply absorption ahead. Our preference here, as indicated before, is via spread assets like SDLs and the best quality AAA corporate bonds; although we must admit to being 10 – 15 bps too early in this trade. Spreads to equivalent government bonds are now in the vicinity of 100 bps for these bonds. Also, the relative excess supply here fades seasonally over the next two quarters. Market for lower rated credits remains dislocated and we would continue to advise caution there. There is a genuine liquidity issue in the lower rate space and this is constraining true price discovery as well. One will have to wait for some of these issues to settle down, and in particular allow price discovery to start happening through the open market, before taking any sort of a serious relook at this space.

 

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

The recent RBI policy, and more particularly the post policy interactions, distinctly bore the mark of the new Governor. Assessments made were bolder and unequivocally benign. There was much more sympathy for the government including for the recent interim budget which, it may be remembered, wasn’t as well accepted by the market. Indeed, the Governor went so far as to defend the GST assumptions in the budget and even highlighted that the slippage from targets is modest. The reaction function of RBI / MPC was laid out with much more decisiveness as the headline CPI as well. Also, the forecast for CPI seems more decisively sanguine with Governor Das indicating that the projections have taken into account the possible inflationary impact of the budget’s farm income scheme. In summary then the Governor seemed completely relaxed on CPI, including on the effect on it from the budget, and seemed firmly focused now on helping growth. In this context, the RBI assessed that some output gap may have again opened up versus its assessment in December that the output gap remains virtually closed.
 
While this commentary had already started expectations of another cut in April, the majority first reaction to the RBI’s inflation assessment was that it risked being a shade too sanguine. However, the recently released CPI data has aligned market much more firmly with the assessment made by the central bank. Thus the CPI for January at 2.05% has undershot market expectations by a full 50 bps or more. This will likely lead to RBI’s latest downwardly revised Q4 CPI estimate of 2.8% getting undershot again. Not just that, the Q3 FY 20 forecast of 3.9% now seems much more comfortable than before. The internals of the latest CPI print were quite subdued as well, as shown in the various cuts presented below (source for all charts is CEIC).
 
graph1_2617

 
Notable here is the deceleration in core CPI as the recent (mysterious) spikes in health and education have subsided. Although the level of core is still uncomfortably high, the directional view will matter more and so long as the momentum on this continues to be subdued it may not be a worry either for RBI or for markets. Also notable here is the chart on CPI ex of vegetables, fruits and pulses. Even excluding these 3 items that are in deflation currently, CPI is at its lowest ever in this CPI series.

 

Takeaways
 
As things stand, the new decisive RBI seems more in tune with both the global backdrop as well as local developments on CPI. The global slowdown in data continues and on the margin is inviting shifts from other central banks as well including, and most notably, from the US Fed. This then remains a very positive environment for bonds. With the last CPI undershoot locally, April rate cut is largely cemented in market’s expectation and one cannot rule out one more cut after that as well. This is especially if RBI gets more concrete signs that growth is slowing and output gap is widening more.
 
For bonds, historically the two large anchors have been inflation and fiscal. Each is however a necessary condition but not a sufficient one as the current phase in bonds is so painfully demonstrating. Thus if a few years back a discussion had ensued that India will probably post 3 successive years of sub 4% CPI, most may have opined that the 10 year government bond will likely be around 6.5% or lower. CPI has probably delivered and yet bonds are stuck in a frustratingly elevated range for now, and even after significant supply absorption by RBI via open market operations (OMOs) . Even more, state development loans (SDLs) and quasi sovereign AAA corporate bonds are a full 100 bps over the 10 year government bond and some 500 bps over average CPI! This is a simple instance of substantial crowding out and macro policy makers have to pay attention to this irrespective of optical consolidation endeavors for the public deficit. If a quasi-government institution is forced to borrow at 500 bps real yield (assuming that the current CPI is representative of the economy), then the bond market has to be considered shut for all practical purposes for long term borrowing by private companies.
 
From a bond strategy standpoint, and notwithstanding the above headwind, real money funds with active or long mandate may no longer be able to completely ignore the duration part of the curve. This is because the spread between say 4 year and 10 year has widened to almost 40 – 50 bps across SDLs and corporate bonds thereby making the latter somewhat more attractive. Also, from a ‘one and done’ for now kind of hypothesis with respect to rate cuts, most participants are now being forced to consider the possibility of even two more cuts in the current year. Also, given currency in circulation (CIC) trends, it is possible that OMOs continue into April as well. Our preference for duration is largely via the best quality AAA corporate bonds and SDL where spreads are at 100 bps or thereabouts over government bonds. While supply is a near term headwind to these bonds, this pressure is expected to considerably abate into the first part of the new financial year. Thus these constitute an attractive buy and hold trade if one is playing some sort of a structural trade on interest rates. For more conservative investors looking for better risk versus reward optimization, though, the 2- 5 year AAA corporate bond segment continues to look the best placed.
 
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

First Principles fixed income..

By: Suyash Choudhary

The Importance Of ‘First Principles’ When Investing In Debt Mutual Funds
 
A. Identifying Risk in Debt Mutual Funds (MFs)
 
There are two major types of risks associated with a debt MF:
 
1> Interest rate risk: Risk of loss owing to changes in interest rates. This risk is best captured by the duration of the fund.
 
2> Credit risk: Risk of loss owing to change in credit profile of an issuer that leads either to a downgrade or default.
 
B. Identifying own risk profile
 
Most investors in debt mutual funds have been or still are fixed deposit customers. Therefore, it is very important to appropriately identify one’s own risk profile while deciding where to invest. Obviously mutual funds cannot guarantee returns. Therefore if one wants a risk profile that is the closest to a fixed deposit, one has to choose a debt fund that controls both interest rate and credit risk.
 
Right away, one can notice an inconsistency in asset allocations done over the past few years. Thus interest rate risk has always been identified as risk; since it is obviously visible as daily volatility in net asset value (NAV). However, credit risk has largely been called ‘accrual’ and the risk associated here has been underappreciated. Indeed, one has often heard a debate of ‘duration versus accrual’, where ‘duration’ denotes funds that carry interest rate risk and ‘accrual’ denotes funds that carry credit risk. Thus as interest rates turn more volatile one hears the argument that investors should move from duration funds to accrual funds. This is may not be consistent advice; for a couple of reasons:
 
1. A move away from interest rate risk should not automatically mean the embracing of credit risk. Thus the more appropriate advice may have been: if you don’t like volatility associated with duration funds then move to funds with lower duration (short term funds for instance) while keeping credit quality constant. To illustrate further, suppose one were in a dynamic bond fund which was running a combination of AAA and government bonds, but of higher maturity. Then, if the investor wishes to curb the interest rate risk associated with the product, she should move to a short term fund which has lower maturity but has a similar credit risk, i.e. AAA and government bonds. However, by moving to credit risk funds that invest predominantly in AA and below the investor is adding credit risk just as she is reducing interest rate risk. This is akin to switching one risk for another and not really reducing the net risk in the portfolio.
 
2. A better approach is to follow an asset allocation table rather than follow tactical advice, which by itself generally follows the rear-view mirror. Thus if an investor into a mutual fund is conservative (which presumably most debt investors are) then majority of her allocations should be to products most likely to have conservative risk profiles. As explained above, these are funds that control both duration and credit risks. Full AAA funds in the low duration / short term / medium term / corporate bond / Banking PSU categories should fulfill this criterion to a large extent. Such funds should form the majority of allocation for conservative investors. For the rest, one can pursue so called ‘alpha’ oriented strategies. These could be either through funds that take interest rate risk (for instance dynamic bond funds) or those that take credit risk (credit risk funds) or both. So long as such allocations are kept to the margin (as decided basis investor’s risk appetite), then one needn’t do tactical reallocations from time to time. It is to be noted that such tactical reallocations are also tax inefficient or may be subject to exit loads. A probable asset allocation mistake made over the past few years is slotting credit risk funds under the low risk basket where a majority of a fixed income investor’s allocations are made.
 
C. The First Principles Requirements from a Mutual Fund (MF)
 
A MF is a pass through vehicle. It pools investor funds and invests them. In the case of debt fund, these investments are made in the debt market. At some point one or more investors can ask for their money back, if it is an open ended fund. On receiving this request, the fund manager has to sell securities and meet the redemption. As far as possible after this sale has been made and the redemption funded, the character of the fund (in terms of risk profile, company concentration etc) should be similar to what it was before. This is so that the fund remains consistent for the investors who are left behind.
 
The important point here from an investor’s standpoint is that the majority of investments should be liquid; which means that the fund manager should be able to sell them at least in ordinary market conditions. This is important for two reasons: 1> The fund should have ability to fund its redemption and in a manner that doesn’t alter the profile of the residual portfolio. Thus if the fund has a significant exposure to illiquid securities, the fund manager will only be able to sell the liquid part. What is left will have a higher concentration in illiquid securities, which is detrimental to investors who are left behind. 2> Illiquid securities by definition don’t have a market traded price. This means that they get valued on opinion rather than on actual market discovered price. This causes a risk that the NAV of the fund may not appropriately reflect the actual value of its underlying securities. This should be a cause for concern for both existing as well as new investors into the fund. This risk is quite real as market data shows that a majority of securities rated A and below haven’t traded at all since the beginning of this financial year. This creates a large illiquidity as well as price discovery risk for funds that are holding such paper.
 
D. Some False Premises
 
There are some false premises in debt fund investing that one should be aware of:
 
1. MFs can manage liquidity via exit loads: In many cases chiefly for credit risk funds, because a significant part of the portfolio consists of illiquid securities, the fund manager relies on suitable exit loads to deter redemption. In some sense, some sort of an asset liability management (ALM) framework is used. So asset maturity is in ‘buckets’ basis the exit load periods of investors. Exit loads are no doubt a large detriment for redeeming from a mutual fund. However, by no stretch of the imagination can they be relied upon as a sufficiently high detriment. As discussed before, MFs are pass through vehicles. They aren’t static balance sheets like a bank or non bank finance company (NBFCs) where liabilities may have a defined maturity profile. As has already been shown in the Indian market as well, if the investor concern is strong enough, she can pay exit load and redeem. This leaves the portfolio with all the problems described above in connection with illiquid securities. In some sense also, the point circles back to appropriate asset allocation. If the investor has allocated to credit risk funds under her predominant low risk bucket, then the likelihood of a panic exit is that much higher when things turn for the worse.
 
2. Even AAA can default, so why bother? : Recent events have evoked this response in certain quarters. As an admittedly extreme analogy this is somewhat akin to saying food can sometimes make you choke, so why eat! The probability of AAA defaulting is negligible. This has been proved with data over multiple decades. This doesn’t mean it can never happen. However, to use a once-in-a-blue moon default and paint a general principle is not advisable at all. Also with some due diligence, the weaker AAA can be generally weeded out by the fund manager in most cases.
 
Conclusions
 
The attempt here has been to highlight some first principles that will hopefully serve well when making allocations to fixed income mutual funds. Some of the key takeaways are summarized below:
 
1. Investors should first be aware of individual risk profile. Assuming debt investments are first made for conservatism, a majority of allocations should be to full AAA funds in the low duration / short term / medium term / corporate bond / Banking PSU categories.
 
2. Credit is a risk just like interest rates are. It can lead to both positive as well as negative outcomes. The key is to allocate to both credit and duration in the so-called ‘alpha’ bucket’ and not in the core debt allocation bucket.
 
3. An open ended debt mutual fund should first and foremost fulfill the criterion that a majority of its portfolio should have liquidity and price discovery via the open market. This enables seamless redemption management, consistency in portfolio profile even with inflows and redemptions, and the discovery of NAV that is largely accurate.
 
4. A lot of discussion on credit revolves around quality of manager and depth of research process. What is equally important, however, is to ask this: Is the nature of risk being taken consistent with the vehicle being used to take the risk? More specifically, are open ended mutual funds the appropriate vehicle to take on such positions?
 

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 best 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 RBI cut policy rates by 25 bps to 6.25% (voted 4-2) and changed the monetary policy stance from ‘calibrated tightening’ to ‘neutral’ (unanimous vote).

 
Some key points:
1. The MPC cut its CPI forecasts, with Q4 FY19 now being forecasted at 2.8% y/y (vs. the lower-than-expected actual print of 2.6% in Q3 FY19 and previous forecast of 2.7-3.2% for H2 FY19) and H1 FY20 at 3.2-3.4% (previously 3.8-4.2%). CPI for Q3 FY20 is forecasted at 3.9%. It assessed the risks to be broadly balanced around the central trajectory vs. ‘tilted to the upside’ earlier. The MPC noted its benign food inflation outlook, softer prices of items in the fuel-group, complete dissipation of the recent HRA hike and its current judgment of the recent jump in health and education CPI components to be a one-off phenomenon. However, it highlighted the reversal in vegetable prices, unclear oil price outlook, rising trade tensions, volatility in financial markets and the impact of various budget announcements (although only over a period of time) on increasing disposable incomes as upside risks.
 
2. On GDP growth, it noted slowing global growth/demand, rising trade tensions and the recent pickup in bank credit growth not being broad-based as headwinds. It projects FY20 real GDP growth at 7.4% (7.2-7.4% in H1 and 7.5% in Q3), with risks evenly balanced. Further, it mentioned the output gap has inched lower than potential (earlier assessment was it had closed) and the need to step up private investments and support consumption. On the global front, it acknowledged the recent moderation in economic activity in the U.S., Euro Area and China.
 
Takeaways:
 
The rate cut decision taken by the MPC is understandable, although market (including ourselves) had assigned a less than even chance of that happening today. This is largely owing to the context provided by the Budget and the expectation that the recent jump in core CPI, although owing largely to rural health and education, may cause RBI to take more time it its assessment. However, the cut can be justified owing to the persistent undershoot in headline CPI as well as more sanguine global environment, including worries on global growth. Indeed, that has been our framework for some time now. What stands out, however, is that the assessment is considerably more sanguine on almost all aspects. As an example, the Governor actually stepped in to defend the GST collection targets set by the government in the new budget; one which has been viewed with suspicion by most. Also, the impression given is that the new revised CPI targets take into account possible impact from the consumption stimulus offered by the government in the budget.
 
The policy clearly has the stamp of the new Governor. Assessments are bolder and interpretations are more sanguine. There is clear benefit of doubt for the government. Also, the focus seems conclusively back on headline CPI. All this means that the market may look forward to at least one more rate cut, given that the near forecast for CPI remains sanguine. Against this tailwind, however, the government is slated to borrow INR 36,000 crores extra in this financial year and a higher than expected INR 7,10,000 crores in the next financial year.
 

The obvious implication is for the yield curve to steepen as the market is called upon to take higher supply at the duration part of the curve. In duration our preference would be for quasi like SDL and corporate bonds rather than government bonds. While supply there is a near term problem, it typically dissipates into the new financial year. Also, starting spreads there are already reflecting higher supply. The most sustainable trade, however, is in 2 – 5 year AAA corporate bonds.
 
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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