The West Asia conflict is now more than a month old, despite recurring optimism for a conclusion. The energy shock continues alongside, with concerns rising as inventories deplete. The supply hit is not limited to energy only but to other commodities as well, both directly as well as indirectly via escalation in transportation costs. The time spent in the situation so far is forcing analysts, market participants, and central banks to start to think about this as more than just a passing episode. This is both considering the duration of the shock thus far as well as considering the more permanent damage sustained by key gas facilities in the region that may delay full restoration of supply for a lengthy time frame.
Indian bond yields have also started reflecting the above progression. In the initial period bond yields barely budged, largely reflecting RBI’s heavy bond purchases at the time. Most of the pressure during that phase was borne by interest rate swaps and corporate bond yields. However, the central bank has stepped back over the past couple of weeks. This, alongside heavy SDL supply and increased pessimism with respect to the duration of the war, has finally led government bond yields to rise substantially. The last few days have been notable where almost all market yields (government bonds, bank CDs, corporate bonds, swaps) have spiked even higher, and quite sharply so.
A proximate reason for the most recent sharp rise in yields seems to be, almost counter-intuitively, RBI’s stepping up administrative measures to defend the rupee. Instead of the bond market drawing comfort from the arrest (at least temporarily) in the rupee fall, it is instead forced to ask the question: does this bring a shift in monetary policy approach as well? More specifically, the worry increasingly is whether early rate hikes may be in the offing aimed not just at new inflationary pressures because of the war but also to try and mitigate currency pressures.
Sifting Through Shifts
It is quite striking how much ground we have covered on monetary policy from ‘here or lower for longer’ to worrying about imminent (and judging by market pricing, substantial) rate hikes. Of course, there is a very large supply shock to contend with now which wasn’t there before and which the Governor had distinctly mentioned as a qualifier. Also, market yields don’t just reflect exact mathematical expectations of policy rate changes but are also considerably influenced by participants managing their risk positions. Thus, there may distinctly be overshoots in play for now which will probably smoothen out in the time ahead as volatility starts to normalise.
In our own framework, we have been bothered by the lack of sufficient net capital flow and whether it has implications for the sustainable level of current account balance and hence interest rates. Put another way, a question we have struggled with is this: if sustainable level of current account deficit has moved lower then does it mean that the sustainable neutral level of rates has moved higher? For that reason, we have been somewhat uncomfortable with the lower for longer narrative and particularly the additional easing that RBI had undertaken since December by actively injecting ‘dovish uncertainty’ in the market. This had largely taken two forms: 1> stepped up intervention in the government bond market despite healthy spot levels of rupee system liquidity 2> stopping variable rate operations to absorb excess liquidity that led to collateralized overnight rates falling to levels much below the policy rate. To be clear, we did recognise that the inflation-growth trade-off was favourable and hence allowed the continued focus on transmission. However, the worry for us as expressed above (and before) was more around the external account potentially challenging the narrative as well as our confusion with respect to the need for stepped up easing since December via the two channels mentioned here.
For the above reason(s), our portfolio approach was clear: look for relative value where change in policy rates will have lesser effects, keep duration underweight, and use swaps where needed since they seemed to be cheap protection. Since the non-SLR curve had already moved up and flattened (reflecting credit to deposit ratio stress and not any change to repo rate expectations), we have been comfortable running positions here hedged where needed via swaps. We remained strongly underweight duration as well as underweight government bonds which we thought were being held back by heavy bond purchase by the RBI.
However, as noted above, substantial changes have happened over the past few weeks. Two notable ones from our perspective have been: 1> government bond yields have moved up, and the curve has started to flatten as we would have expected 2> swap rates have spiked and are no longer offering any obvious protection (they are accounting for very substantial rate hikes already at their current levels). Given these developments, we have generally unwound swaps and added government bonds (largely 14- and 40-years maturities, consistent with our view of curve flattening) across a host of our portfolios. In the process, we have also gone from being substantially underweight on portfolio durations generally to more market neutral or slightly over/under-weight positions. It is to be noted that though one talks in generalised terms here, individual portfolio strategies would vary depending upon mandate, positioning, and individual fund manager approach.
Extreme Swings
Apart from market developments as noted above that have led to strategy shifts for us, the macro-economic logic for raising duration has largely been basis the following developments:
- In the first 3 weeks of the war, global markets were largely focussed only on the inflationary impact. In many major markets like Euro and UK, markets went from pricing some bit of central bank easing to rate hikes, whereas in the US all future Fed rate cuts were priced out. While this is still the case broadly speaking, there is nevertheless some shift in market concerns over the past week from inflation alone to now considering the growth damage as well. Thus, the policy rate sensitive 2-year bond yields in major developed markets have fallen over the past few days. This is especially true for the US where the Fed has a dual mandate (inflation and labour market) and thus needs to be more mindful of growth as well.
- The narrative for RBI has shifted aggressively in favour of expecting policy tightening, with parallels getting drawn with the post pandemic policy rate hikes starting 2022 (indeed we ourselves had done so in our previous note a month back). It may be recalled that was a period of rapid rate adjustments, also in response to a commodity shock triggered by the Russia-Ukraine war. However, as some economists have already noted, the current episode is not just a price shock but a quantity one as well and therefore sits somewhere between the 2020 pandemic episode and the 2022 commodity shock in terms of its features. As is well known and understood, the first of these had brought central bank easing and the second tightening. While no one is arguing for rate easing in the context of India, the extent of hikes priced now also seem more than adequate given the dual nature of the shock. Also, with the latest administrative measures on currency from the RBI, some memories of 2013 are also getting invoked. While it is true that the overall external account is under pressure, the current account and inflation dynamics are very different from 2013. Furthermore, while we have wondered whether neutral rates should be higher basis what looks like a lower current account deficit sustainability, it is important to note that this argument is incremental. It is largely meant to push against the ‘lower for longer’ theme presented almost as an automatic base case. By no means are we suggesting that a ‘rate defence’ is needed.
- The finance ministry still seems seriously endeavouring to keep fiscal deficit targets intact. This is despite the recent steep cut in excise duties on petro products, as well as the obvious upward pressure on the fertiliser subsidy bill. The hike in export duties as well as the economic stabilisation fund will partly mitigate the impact. Nevertheless, the ability to hold on to fiscal targets will eventually depend on the size and persistence of the current shock. However, the point is not about a few bps of slippage but whether intent on fiscal management may be shifting. And this doesn’t look to be the case thus far at all.
Basis the above, change in valuations as well as the macro points, we have added duration. This is largely via unwinding swaps and adding 14- and 40-years government bonds (as per individual fund mandates). In some sense then, we are moving towards a more ‘bar-belled’ approach which is consistent with our expectation of relatively flat yield curves given the current environment. Of course, portfolio strategies also vary from fund to fund depending upon mandates and positioning. Finally, one must recognise that though valuations have cheapened, it is also true that the neutral levels of rates have likely moved up. Thus, focus on risk management, as well as sufficiently long investment horizons alongside a healthy appetite for absorbing short term volatility, is still as much the need of the hour as it was a month ago.
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.