The last few days of geo-political developments constitute a major supply shock across commodities. This isn’t just restricted to oil and related complex, but also potentially extends outwards via pressures from cost, availability, and time-extensions of freight transport. The general expectation is of a relative short war followed by return to normalcy. We have nothing by way of expertise in the matter and will therefore resist opining on this expectation. Rather, our objective here will be to examine potential channels of transmission given starting point. Also, an important point of note: our analysis here only pertains to macros and markets.
Starting Point:
- Most global central banks are at or towards the bottom of the easing cycle: The narrative across many markets with respect to central banks currently is that of a long hold ahead, after a period of easing. There are obviously exceptions on either side, with some like Australia and Japan either hiked or hiking and others like US and UK still expected to cut somewhat. However, the general point here is that central bank reaction functions may tend to be different if a new inflation shock occurs at a high point on the policy rate cycle vs when it occurs at the low point. Of course, individual domestic trade-offs also matter here. Thus, extent of susceptibility, room for manoeuvring, and judgement whether this is to be treated as a short period supply shock with limited pass-through or something more sustainable with potential second order effects, will all have a bearing on how individual central banks perceive this new development.
- US is still facing sticky core inflation, even as insurance cuts are over: Responding to an intermediate weakness in the labour market, the Fed has responded with 75 bps of additional cut since September of last year. The incremental commentary now is more mixed with both the FOMC members as well as markets divided on the way forward. On the one hand, the labour market is yet to find firm footing, and some have argued for further disruptive effects from AI also needing monetary support. On the other, core inflation remains sticky for now, labour supply growth is also weak, and there is incremental fiscal easing in the pipeline from OBBB Act last year. The net expectation, however, still has been of around 50 bps of additional easing over the course of the next 6 months or so. One has to see whether this cut expectation starts to unwind given 1> core PCE inflation still at 3% 2> recent evidence of some broad basing in economic growth drivers. Indeed, it is noteworthy that as the first response to the crisis, bond yields are rising as market is prioritising the inflation effect over flight to safety.
- Industrial metal prices have been rising since late last year: While a lot of commentary here has been around supply disruptions, the price rise may also be reflecting better demand and a hint of a so-called ‘reflation’ trade. The thesis finds further support if one notes that global manufacturing PMIs have been generally on an upswing since mid of 2025. Industrial capex has been picking up aided by AI investments in US and defence and infrastructure in Europe. With better fiscal support and recent broad basing in manufacturing, the pressure on central banks to do more on growth was anyway depleting. Of course, one can take a view here that the geo-political shock, if it persists, may also dent the appetite for continued manufacturing expansion. A lot will depend upon the intensity and duration of the shock and whether it meaningfully nudges inflation expectations higher or not.
- India has lost net capital flows for close to two years: This is stated here neither as a particular insightful observation (everyone knows and talks about this) nor as a point of alarm, but merely as a macro-economic consideration that sits towards the top of the list for India. While our macro-narrative remains strong, there are other attractive avenues for global capital now that weren’t in play a few years back. These include much higher developed market bond yields than before, as well as the AI narrative. Further, the new geo-political escalation may bring volatility to global capital allocation. Thus, if we are to get our fair share of global capital, a combination of strong macro-narrative and reasonably attractively priced asset markets may be almost hygiene given the current global backdrop. Correspondingly, the degrees of freedom with monetary policy may be somewhat lower as well.
Transmission Channels
We turn next to a couple of obvious, and related, channels of transmission should the commodity price and related effects persist beyond a very short period. A point of note here: one has to look for not just prices to stop rising but for them to fall back meaningfully so that the episode can really be looked at as a transient supply shock with no second order effects. This requires transportation costs and re-routings to normalise as well.
For Indian bonds, the channels that would matter are: 1> incremental impact on currency and the external account 2> changes in RBI’s (and market’s) forward looking inflation expectation. There is potentially a fiscal channel as well in the form of higher subsidy bill, but we won’t dwell on this just yet, given that the government may be able to use other levers to compensate for any subsidy expansion.
It is to be noted that the first of the above, currency and capital flow impact, is almost considered a bullish factor for government bonds lately with the logic running:
Weaker capital flow = more rupee weakness = more RBI intervention = more bond purchases from RBI = better demand for bonds
This causation has if anything strengthened lately with secondary market government bond purchases from the central bank apparently getting scaled up. It is possible that the central bank is delivering on its commitment on forward looking and proactive liquidity infusions by pairing currency interventions with bond purchases. This is despite durable system liquidity on a spot basis being more than adequately comfortable (INR 5.6 lakh crores as at 15th February). The alternate view, that RBI is managing yields, has also gained ground lately. If true, it is a tricky one for the central bank to manage going forward for a variety of reasons: One, we are no longer in a pandemic shock scenario where yield level control may even remotely be justifiable. Two, growth isn’t faltering or at least the marginal utility of a 15 – 20 bps bond yield change contribution to economic growth isn’t obvious. Three, sustained intervention in the bond market may risk creating an inadvertent moral hazard problem where commercial demand for bonds is largely banking on RBI as the last resort buyer to bail it out.
To return to the initial point, at some juncture weaker currency and capital flows risk flipping into a bond negative factor. Our own bullish call on duration from a couple of years ago rested first and foremost on what we saw as a compression in India’s current account deficit courtesy the rise in services trade surplus. However, there is rising risk to this compression sustaining should software services and remittances take a hit from AI and, more recently, from geopolitics. Also, it’s an open question whether one should relook at what a sustainable level of current account deficit should be, given many other avenues also competing for global capital now. Thus, the external account has turned into an area of caution for us rather than a bullish tailwind for bonds. Also, continued currency pressures have an inflation pass through as well which may need to be reckoned with sooner or later.
This brings us to the second channel: changes in expectations. We hesitate to draw parallels, but one lesson from the 2022-23 period has been that commodity shocks, especially when backed with conducive underlying conditions, can quickly alter forward looking policy rate expectations. As discussed above, there had been recent tailwinds to global growth, and many central banks are at relatively loose monetary policy settings. In fact there is net new fiscal easing as well in major developed markets. And now we are getting a commodity price shock, though its longevity is yet to be ascertained. Thus, one cannot really rule out a shift in market rate expectations, even ahead of actual inflation data turning.
In the case of India, RBI has recently introduced a new element of ‘dovish uncertainty’ via two mechanisms: One, it has stopped doing VRRR operations for some time thereby allowing collateralized overnight rates to fall below 5%. Two, it seems to be also buying bonds on screen thereby setting market expectation of a central bank backstop. Thus, should its forward-looking assessment turn, the potential for a market expectation shock is that much higher.
Conclusion and Takeaways
India’s inflation remains well contained for now, thereby allowing RBI to sustain an accommodative policy environment. If anything, the central bank is recently proactively injecting dovish uncertainty in the market. Also, the Governor opined in a recent interview that rates are likely to be around this level or lower for a long time. He did, however, qualify that this was barring any shocks. While too soon to tell on durability, the ongoing geopolitical developments can easily be classified as a major shock. Both the starting point for this, as well as the potential intensity, can alter monetary policy expectations going forward. This is true not just here but in other major markets like the US as well.
Indeed, in the case of US bonds inflation concerns have so far trumped safe haven demand leading to a rise in yields since the crisis started. Ironically, presumably owing to RBI’s heavy hand in the market, India bond yields have shown very little net movement. This is even though the direct impact on India is much larger since we net import a lot of our energy requirement. As discussed above, to the extent this represents a proactive liquidity approach, it is understandable. However, having used bond purchases heavily over the past 14 months, it is probably time for RBI to explore other tools for liquidity intervention more, including purchase of short maturity treasury bills if needed. This will allow market forces to more fully be expressed in the bond market and correct the moral hazard problem that is already beginning to build in the market.
From our standpoint, we remain underweight duration and are using a mix of front end non-SLR rates, hedged where required by interest rate swaps. It is to be noted that the evolving scenario, if prolonged, ultimately argues for flatter not steeper yield curves should market’s policy rate expectations start to exhibit a shift. The non-SLR curve is already flat given the pressure on credit to deposit ratio seen over the past few months. This, alongside the very attractive carry available here, keeps us reasonably comfortable with our non-SLR positions (up to 3 years largely) hedged where needed via interest rate swaps.
The government bond curve presents a dilemma: owing to RBI action and its current forward guidance it remains quite steep. Thus, the front- end points look unattractive. To elaborate, yields are fine in relation to current overnight rates but too low if one expects some sort of policy expectation reversal over the next 3 – 6 months. Long duration yields are better valued but we don’t have any confidence yet that there can’t be further mark to market losses here. Hence, it is difficult to position at the long end especially if, as we are, one is reluctant to meaningfully expand portfolio duration at this juncture. This keeps us underweight government bonds, even as continued RBI intervention can keep a lid on yields for some time.
To clarify, if we were only underweight duration owing to technical demand-supply reasons (that is demand in relation to supply keeping prospects of change in demand basis change in expectation constant) then there may have been a case to revisit the view. However, the argument presented above is for a period of more fundamental caution and conservative portfolio stance. This seems inconsistent with putting on duration bonds. As always, however, this represents our thinking at this point in time and this can change at any point going forward.
In summary, there are sufficient outlier risks to the current scenario that warrant a strong element of caution and value consciousness when picking where to invest. Keeping duration risk low and investment horizons longer than usual seems a good way to play this environment, pending more clarity emerging.
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 Bandhan Mutual. 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, if any, 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/document as may be required from time to time. Neither Bandhan Mutual Fund / Bandhan Mutual Fund Trustee Limited / Bandhan AMC Limited, 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. Past performance may or may not be sustained in future.