By Suyash Choudhary
After the recent monetary policy, the Reserve Bank of India (RBI)/Monetary Policy Committee (MPC) are now emphatically firing on all three cylinders of rates, liquidity, and guidance. There is some appreciation subsequently, in the very front end of the rate curve of this new reality, as demonstrated by the 91-day treasury bill yield now moving below the repo rate.
Markets, however, remain broadly unimpressed slightly higher up the curve, with bonds even from 3 to 4-year onwards barely budging much. Whereas, yields at the longer end of the yield curve are demonstrating no sign whatsoever of the visible easing bias embedded in monetary policy. As an example, the relatively well traded 14-year government bond is comfortably sitting almost 200 basis points (bps) over the repo rate.
An added dimension of the macro picture:
The significant growth slowdown globally, amplified in India owing to a noticeably slowing consumer, is now well documented. This has triggered monetary easing across most of the world. India has been proactive amidst emerging markets with 135 bps already delivered backed by liquidity and guidance as well, as noted above. Concurrent data suggests that the growth slowdown is still in play, thereby keeping alive hopes for more easing.
A new development is the US Fed deciding to restart a measured expansion of its balance sheet in response to recent sharp surges in overnight rates triggered, amongst other things, by banks no longer holding sufficient excess reserves. This marks a reversal from the ‘quantitative tightening’ that the Fed had embarked upon since late 2017, as depicted in the chart below.
It is no surprise that the dollar has been unilaterally strengthening almost exactly since the Fed began its balance sheet shrinkage, thereby curtailing the global supply of dollar liquidity.
Of course, there are other aspects at play as well, including the general expected divergences in monetary policy more broadly. However, the Fed’s actions definitely had an impact on both actual and perceived dollar liquidity availability in the global financial system.
As is well known in times of a rising dollar emerging markets, those, especially who run a current account deficit (like us) or are more open to capital flows, have to run a much tighter ship with corresponding constraints on pursuing expansionary policy. However, it is likely that basis the above observations, this phase of an aggressively rising dollar may be ending (barring on a renewed bout of risk aversion). This is an added benefit for many emerging markets and allows for prioritizing the objective of growth with much greater safety.
An added benefit for India purely from the aspect of external stability, is the recent likely compression in our current account deficit. This compression is most probably cyclical, reflecting weakness in domestic demand rather than a new found broad-based net export competitiveness. However, alongside a more stable dollar, this compression again buffers us against potential external headwinds to some extent and, ceteris paribus, allows for the pursuit of (say) looser monetary policy without courting near-term instability risks.
To summarize, a weak growth-inflation outlook is being augmented by a reasonable stable external risk profile (barring global shocks triggering risk aversion). This should also prima facie boost the demand for Indian assets including bonds, as well as allow for easier tapping of offshore markets by local borrowers.
In this context, it is also a very opportune time for the discussed-to-bits sovereign issue that has been recently contemplated in India. The primary concern that we may overdo this can be overcome by some rule-based metric and should not stand in the way of issuance of the bond itself, especially given that the most notable feature of India’s current macro is the stark unavailability of adequate risk capital, both to assume market and credit risks.
Many coats on the fiscal peg:
It is quite noticeable that term spreads should be so elevated at this point of the cycle. This is considering both local and global macro, as well as the guidance and liquidity coming through from the RBI. The problem really, as noted, is the unavailability of enough capital willing to assume the additional market risk. A circa INR 2,00,000 crore positive liquidity is also not necessarily improving risk appetite for market participants.
The dominant reason for this of course is continued fiscal fears. These are on account of both the weak revenue growth so far in context of fiscal measures already announced (although it is now clearer that the revenue forgone this year on account of recent corporate tax cuts is nowhere close to the amount indicated earlier) as well as the ‘optionality’ that the government continues to retain with respect to announcing further measures.
If the government were thinking about this holistically it would probably realize that this open ended optionality is coming at the cost of one more impediment to monetary transmission into lending rates (higher bond yields) and hence it is best to put this to rest one way or another. It would also then look at the benefits from incremental measures against the cost of this blockage. However, thus far, the market is not convinced that the government is thinking in this direction. Indeed, the recent somewhat conciliatory statements by the Finance Minister on an international platform around our path of fiscal consolidation have been largely ignored by the market. The wariness also is on account of speculation that an income tax cut may be just around the corner.
The above said, and at risk that the next large fiscal measure may get announced before the proverbial ink has dried on this paper, it is also possible to envisage that the bond market may be over-playing the fiscal risk given everything else that is unequivocally bond positive. This includes this latest development on the external front that is largely the theme of this note. The big risk, as noted, is also from higher state development loan (SDL) supply. However, so far, banks have been quite willing to anchor this asset class leading to a 10-20 bps overvaluation here when compared with the long end of the government bond curve. Thus, it can be argued, there is some cushion for SDL yields to rise somewhat without really impacting the sovereign curve significantly.
Reflecting all of this, we have tactically raised our allocation to the 10 to 14-year segment again in our active duration products. While this trade is not as well anchored as the front end (and hence needs monitoring actively), we do sense that the market is currently quite agnostic to what is otherwise a reasonably constructive environment for rates. The obvious risk is something meaningful incrementally done on the fiscal side.
A new thought that we are harboring is also that, while we are quite confident about our ‘lower for longer’ hypothesis on policy rates backed by surplus liquidity (which makes front end rates a very obvious lucrative trade), one should yet not turn too judgmental on what exactly is the terminal rate in this cycle. The argument that terminal rate is very close cannot rest on the macro scenario. This requires much more support from policy as the continued spate of weak concurrent data suggests. Rather the judgment call at some juncture will lie in the efficacy of further cuts, as demonstrated in the potential inability of banks to keep passing lower rates. Bond investors don’t need a resolution on this debate immediately, given that there is more than adequate room for term spreads to compress on the current curve structure itself.
(Suyash Choudhary is Head of Fixed Income, IDFC AMC. The opinion expressed are personal)