Despite a very dovish December RBI policy and further follow up actions to shore up core system liquidity, financial conditions have remained generally tight. This has been evidenced in government bond yields stubbornly refusing to move down as well as non-SLR rates continuing to move up. Indeed, the pressure is being seen even in very front- end money market rates. To be sure, there is likely to be a lagged impact of recent RBI easing so that there may be likelihood of some relief ahead. On the other hand, rupee pressure persists, and the central bank seems to be continuing to intervene to smoothen the depreciation. This has consequent follow- on effect on system liquidity. Thus, till the rupee finds stability on its own, there is a bit of a ‘treadmill’ effect so that while the central bank can provide temporary relief, it is hard for financial conditions to sustainably ease.
Largely reflecting this dynamic, as well as the sustained underlying muted bond demand in relation to supply, we had reduced maturities and raise cash / quasi cash levels in our portfolios in November last year. Subsequently, market yields had risen, and the yield curve had ‘bear flattened’ somewhat (larger underperformance in shorter end rates). With an eye out for a potentially dovish December RBI policy, we had used this opportunity to re-deploy cash and regained our overweight 5 – 8 year positions. However, subsequent developments have provided lesser confidence with respect to this strategy. While bond yields have been relatively range bound (largely reflecting INR 3 lakh crores of OMO purchases), the general environment is otherwise less friendly, thus highlighting the value in retaining portfolio flexibilities. Considering this assessment, we have reverted to a defensive stance for now.
The Glass Half Perspectives
If the viewpoint above sounds too bearish, then we should also highlight that there are plenty of reasons to consider the glass half full as well. In fair representation to both sides of the equation, we summarise below both bullish and bearish factors to the best of our assessment. It is to be noted that some factors mentioned below may be common for both sides and one’s interpretation of their impact really depends upon one’s point of view:
Half Full:
- RBI bond purchases and dovish forward guidance: The central bank has been very proactive in shoring up core system liquidity. Consequently, the pace of bond purchases has positively surprised most market participants. Should future forex operations continue, one cannot rule out even more bond purchases before the end of the financial year. Furthermore, with external headwinds to growth persisting, the RBI / MPC may continue with a relatively dovish forward guidance on policy rates for some time more.
- Replacement SLR buying: Bank demand for SLR has been relatively muted lately. However, with OMOs and bond maturities, replacement demand may now very well be forthcoming especially as there has been some downward adjustments in liquidity coverage ratio (LCR) of many banks.
- Rupee adjustment having relieved some pressure: The rupee has underperformed many peers’ currencies over the past year in a broad environment of weaker and then sideways dollar index. Thus, one can argue that most of the adjustment may potentially be behind us and some turn in narrative may very well bring stability to the currency which in turn can then become a self-reinforcing mechanism.
- Possible further bond index inclusion: Market is hopeful of India’s inclusion in Bloomberg Global Aggregate Index. Whether or not this happens will likely be known shortly. However, in the list of glass half full triggers we would consider this amongst the last. The inclusion, if it happens, would potentially bring USD 15 – 20 billion dollars’ worth of local bond demand over a one-year period or so. That amount pales in comparison to the amount of bond purchase RBI has been doing over much shorter time horizons.
Half Empty:
- System Risk Appetite Remains Muted: Despite all of RBI measures on rates, guidance, and bond purchases, market participants still seem to be exhibiting limited risk appetite. Though RBI OMOs can still generate replacement demand as noted above, they still don’t seem to have the market moving effect that they would otherwise have in a period of normal market risk appetite.
- Incremental credit to deposit ratio is high: The rise in incremental CD ratio may be an added disincentive for banks to expand their investment books. By putting upward pressure on deposit rates and the front end of the non SLR curve, the tighter CD ratio also generates carry options for real money investors who don’t want to immediately deploy in duration assets.
- Global geo-political uncertainties: These have risen substantially again, including in the Middle East which has direct consequence for oil prices. Though thus far the narrative on oil has been one of excess supply, there has been some recent life exhibited in these prices reflecting the rising geopolitical risk. Should these manifest further, then the same may also reflect in oil prices. At a time when the rupee is somewhat under pressure and the view on net capital inflow is ambivalent, a rise in oil prices will certainly not be helpful for the mix.
- Rise in global commodity indices: Apart from gold and silver, prices of some industrial metals have also risen sharply since late last year. While the impact to both our trade account as well as on inflation is limited so far, this nevertheless bears watching. the commentary thus far relates to supply disruptions driving prices, but one must be watchful whether there is an element of a ‘reflation’ trade (better growth, demand side inflation) lurking somewhere here as well.
- US yields / dollar seeing some signs of life again: The dollar has been in hibernation for most of last year and US yields have followed the better fiscal and rate cut narrative. The Fed has responded to labour market weakness even as overall growth has held up better than initially feared and financial conditions have remained loose in aggregate. In the first part of the new year, US growth may get a leg up again from post shut down effect, Trump budget incentives taking effect, as well as from ongoing AI capex spending. A rise in US yields and / or dollar can potentially be an added source of pressure for global bond yields.
- Uncertainty on US – India trade deal: While the narrative on this keeps shifting, a trade deal with US is still awaited. Further, there is risk of further escalation with a bipartisan bill currently being debated in the US which could impose substantially higher tariffs on countries purchasing Russian oil. While a case may be made that more trade uncertainty equals more dovish RBI for longer, we think the number one macro variable that market is now watching and responding to is the rupee, which in turn is influenced by the state of the balance of payment. Thus, a trade deal being currency positive, will likely be bond positive, ceteris paribus.
- Higher gross bond supply looming: Gross bond supply (centre plus states) is expected to be higher from next year, given there are larger maturities that need refinancing. While some of the net borrowing may very well be shifted to treasury bills, the gross supply will still be large enough for the market to continue demanding a reasonable term spread for its absorption.
Conclusion
Readers will note that our list of ‘glass half empty’ factors outweigh the ‘glass half full’ ones. That is true and explains our conservative duration positioning at this juncture. It is also to be noted that the previous few episodes of FX drawdowns have allowed a recoupment period shortly afterwards. However, if any one or more of 1> higher geo-political uncertainties 2> commodity price escalations 3> continued trade uncertainties 4>renewed life in global yields and/or US dollar, persist then that window for recoupment may get pushed forward thereby keeping the pressure on local assets. Importantly, this could be despite central bank intervention providing periods of relief.
Thus, our net assessment very much leads us to keep some portfolio flexibility with a view towards risk management and be able to respond to evolving situation. Also, carry options are plentiful thereby making cost of waiting that much less painful (outside of SLR portfolios). Should the glass half full factors lean heavier, one could see some rally in bonds. However, the view at the time of writing is to consider the overall picture and be patient for either cheaper valuations or better clarity before taking a very conclusive call. As always, this reflects our view and thinking at the current juncture and these may very well change going forward.
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