We look briefly below at some of the more recent macro-economic and market changes as well as check upon our most updated bond market views and strategies.
1. The dollar has stopped weakening
The year started with relief on the multi-year trend of almost one way dollar strength as some of the components of the so-called US exceptionalism theme seemed to be weakening. Alongside strong overweight positions on all things dollar, this triggered a theme of portfolio diversification. Indeed, while we didn’t feel it in the rupee, a host of emerging market currencies have had a very good run versus the dollar this year till very recently. However, as can be seen from the chart above, both the dollar index as well as the Asia dollar index have stopped falling for sometime now. While some consolidation to any theme is warranted for some time, some of the more recent contributors to the arrest in dollar slide seem to be:
• The narrative on other developed markets including Europe and Japan has stumbled lately thereby making US relatively look good again.
• The twin impact to the US economy from tariffs and fall in immigration has so far been quite muted on aggregate. In turn this is attributable to a variety of reasons: One, average effective tariff rates are still much lower than the announced rates and the hike may yet get arrested if the flurry of actual and proposed trade deals actually stick. Two, the impact of tariffs on end consumers seems to have been delayed as firms have absorbed the costs for now. Three, AI capex has intensified and has been meaningful enough to materially contribute towards overall aggregate growth. Four, financial conditions remain quite loose as the Fed is cutting, asset markets are strong, and credit spreads are generally tight. Thus, while the so-called ‘K’ shape effect has on the margin intensified, consumers overall are in fine shape.
• The fiscal fears at the start of the year have been partly mitigated as tariff revenues have picked up. If these sustain then the medium-term US deficit trajectory is now looking in the 5’s rather than the late 6’s and early 7’s that were being feared earlier.
Also, as a result of better fiscal outcomes thus far, US treasury tightly managing duration issuances, as well as Fed rate cuts being back in play, US bond yields have fallen substantially thus far in the year with duration doing much better than most would have anticipated not too long ago. That said, the market is now pricing in 100 bps more cuts from the Fed and as mentioned above financial conditions are quite loose with growth generally holding better so far and inflation still above target. Thus, a meaningful fall further in treasury yields will probably require some weakness from the asset and / or credit markets that leads market to build even more rate cuts and / or triggers flight to safety allocations to treasuries. Absent that, the best part of the treasury rally seems behind us.
2. RBI has stepped up rupee defence
It may be remembered that after an intense phase of currency defense late last year, which had also led to consequent substantially draw-down in domestic rupee liquidity, the RBI had pared down interventions to a large extent. Of course, the underlying weaker dollar environment also alleviated the pressure somewhat and the time was used judiciously to build back rupee liquidity and roll down some part of the short forward dollar book. More recently, RBI has stepped up rupee support again and the scope of intervention seems significant. The impact on rupee liquidity has also been material. The chart below shows how this has depleted despite the ongoing CRR reductions.
While the drawdown in rupee liquidity is nowhere of the scale of what was seen late last year, the direction of travel is nevertheless something to watch for. Given RBI’s proactive approach to facilitating flow of credit, we expect counter measures soon. Our base case is for OMOs to resume likely totaling to INR 2 lakh crores or more between December and March. However, if the recent dollar bounce (and accompanying rupee weakness) were to persist and RBI continues defending the currency, then the scale of OMOs could potentially be even larger.
Also to be noted, the ‘wedge’ between credit and deposit growth rates has again turned positive (credit growth exceeding deposit growth). This is shown below:
Bond Market Implications
The period of ‘very easy liquidity + easing credit to deposit ratio’ seems transitioning again into ‘some liquidity pressures that need action + some tightness in incremental credit to deposit ratio’. With the broad-based dollar weakness in abeyance for now, it is possible that RBI’s exchange rate interventions continue thereby needing compensatory rupee liquidity infusions. With OMOs back on the radar, and some incremental pressure on non SLR front-end (owing to credit-deposit ratios incrementally having worsened), intermediate duration government bonds come back in play for the foreseeable future as the most efficient means for playing market ‘beta’. More specifically, corporate bond spreads have shrunk somewhat over the past month or so reflecting lack of supply here. This may start to reverse as ‘busy’ season keeps incremental credit-to-deposit ratio under some pressure even as RBI comes back with OMOs thereby helping government bonds. Thus, our preference remains to play ‘beta’ via appropriate maturity government bonds in our short and intermediate duration products.
In our active duration bond and gilt funds, we are comfortable with our overweight 6 – 8 year government bonds stance. There is a nuance here that needs reiteration: The ‘blunt’ phase of maximum duration participation is over, in our view. While there is enough play still left, given the strong probability of one more rate cut and now potentially sizeable OMOs as well, overall market risk appetite is relatively weak, and we are close to the end of the easing cycle. Thus, we expect the yield curve to continue steepening as we drift lower on yields. Indeed, the view was stress-tested recently with a more than anticipated cut to long end supply in H2 g-sec issuance calendar and with Q3 SDL calendar printing lower than expected. In response, the curve ‘bull-flattened’ for a while but gave up all of that and is back to steepening again with long duration under-performing.
Three other points need attention: One, OMOs are generally good for up to 10 year maturities since this is where the maximum tendering happens from, triggering replacement demand for similar maturities. Two, even after the last rate cut, one is looking forward to a long period of overnight rates remaining around 5.25%. This should also keep the steeper yield curves intact. Only when the market starts smelling policy reversal, which is not there in the forecast horizon as of now, does the curve tend to start ‘bear-flattening’. Three, the best of fiscal consolidation is probably behind us. From the next financial year, the government moves to the debt/GDP framework where it can very well work with a fiscal deficit target band rather than a point target. This gives some flexibility to respond to evolving conditions, while keeping focus on the medium-term debt/GDP trajectory. While this may be exactly what the doctor ordered from a macro policy standpoint and is absolutely consistent with the responsible approach the government has shown so far with respect to fiscal policy, market nevertheless responds to the direction of travel. Steeper curves are consistent from this standpoint as well.
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