The underlying framework for assessing global macro remains unchanged for us. This is first and foremost an intense global competition for capital, with the progression summarised as below:
- The pandemic saw a heavy fiscal response from key developed markets leading to both large bond supplies as well as, combined with supply side factors, the rise in durable inflation.
- Even as deficits consolidated from peak levels, they have nevertheless floored at much higher than pre-pandemic levels. The case of the US is notable, where higher floor fiscal deficit may have sustained higher floor economic growth rates even as the question remains why the rationale for higher deficits was seen as continuing even in the face of higher than earlier trend economic growth rates.
- Since last year private capex spending has picked up for the AI buildout and, if anything, has intensified lately. The logical economic progression should be for the government sector to compress deficits to allow for private sector expansion. However, the general assessment remains that likelihood of sustained intentional US fiscal compression is low even as private sector capex is getting ramped up. This is admittedly not limited to the US but is perhaps the most visible there. Also, US dynamics are the most consequential for influencing financial conditions in the rest of the world.
- From a market perspective, the above is akin to a global ‘crowding out’ where capital is asking for higher threshold returns reflected most obviously in rising real yields. It may be noted that the rise in real yields runs counter to the previous wide-spread view that many developed markets will only be able to manage rising debt levels via lower real bond yields (tolerating higher inflation).
- With long period inflation overshoots, recent fresh pressures from commodity prices, and generally robust economic growth contributed to by both higher floor fiscal levels as well as the AI buildout, the Fed is tightening policy into rising bond supply. Had this not been the case, then some potential relief to the crowding out could have been hoped for from central banks expanding their balance sheets. This is clearly not the case, at least for the time being.
- Greater Fed credibility, robust economic growth, rising real yields, and the magnet of AI capex are all contributing to renewed dollar strength lately. Alongside higher commodity prices, this is another complexity for us to navigate. This is especially given the overarching context that, with various themes available as destination, global capital is now seeking a better than earlier narrative (or cheaper than earlier valuation), to sustainably allocate to any one theme.
The Necessary Vs the Sufficient
With recent announcements pertaining to FX derivatives as well as separate window for oil companies, the RBI is now well within the realm of the playbook used earlier of shoring up dollar supplies (via FCNR) to trying to enhance the impact of its intervention in the currency market (though the sequencing this time is different). The so-called elephant in the room is what role interest rates can play and whether that part of the earlier playbook also deserves a second look. It is to this that we turn to next.
The current period can only be compared with the previous one in 2013 from the standpoint that both represent pressure on the external account. The comparison largely stops there. The earlier one was on account of internal imbalances (large current account deficits and persistent CPI inflation) which would have needed correcting anyway overtime even had action not been forcibly triggered on account of the proximate trigger from the so-called Fed ‘taper tantrum’. As opposed to this, the current one is largely owing to the global dynamics as summarised above. The distinction, however, is relevant from considering appropriate policy choices for the current context and not to underplay the gravity of the situation.
In our view the discussion on the role of monetary policy, instead of veering into the extremes of whether to use rates for interest rate defence or not, is better served when viewing from the lens of the necessary vs the sufficient. It is a fact that there is a global competition for capital and that real rate settings seem to be moving up. One can also see that India’s own inflation pressures are rising on the back of broad-based pressures on a host of commodities and with rising signs of generalisation. The sum of the two (higher global real rates and rising local inflationary pressures) point to meeting the necessary condition of realigning our own real policy rates towards the new near-term normal after accounting for the likelihood that average CPI may easily remain 5% plus for the foreseeable forecast horizon. The following points need highlighting:
- Moving real neutral rate setting higher will in all probability do very little in the near term to attract global capital, till either the AI capital intensity and / or the ongoing commodity price pressures abate.
- However, just because the sufficient condition isn’t being met is no reason why the necessary ones should not be put in place. Whenever global capital flow starts to reassess destination, India should be right there in terms of conventional monetary policy setting, competing at the level of real yield incentive.
- There is, in our view, some asymmetry in perceived impact of policy decision making at the current juncture: it is probably better for RBI to forecast conservatively with adequate room for error and act accordingly, rather than run the risk of being perceived as being ‘behind the curve’.
- To be clear, what is being talked about here is within the realm of conventional monetary policy setting, targeting an adequate real rate given global realities and evolving local inflation. Specifically, it is not any suggestion of mounting a large interest rate defence.
- The counterpoint, however, is also true: just as there is no case for an aggressive interest rate defence, one should equally not get caught in inaction on grounds of impact on economic growth and to bond market yields. The whole point of hiking rates is to manage demand (vs supply) and improve real incentives for savers. From an external account standpoint, this contributes to managing the current account deficit which, though not currently high from historical context, is nevertheless proving to be difficult to finance given the new dynamics on global capital flow.
Conclusion
There are significant factors in play determining at least the short-term direction of global capital. We have touched upon many of these in the points above. While it is always possible that some of these change direction thereby also triggering a change in the direction of capital allocation, one cannot rely on this happening. Meanwhile, the thresholds to be met for attracting sustained flows have set higher. This has reflected in we not receiving our normal share of capital flows despite running sound macros with no visible imbalances. Monetary policy must meet the necessary conditions even as sufficient ones may not be in our hands.
At some juncture, there may even be a case to revisit, but to a limited degree only, the fiscal-monetary mix (slightly looser fiscal policy but compensated for with tighter monetary policy). This may serve the dual objective of 1> enhancing flexibility to allocate more to highest multiplier effect spending even as pressure from revenue spending is rising simultaneously, 2> while at the same time keeping real bond yields at levels that look competitive globally. Two points need emphasizing here: 1> this can be done only within tight limits largely to address the rising constraints from revenue spending even as the need to maintain (or even enhance) productive spending is more than ever 2> both the mix of enhanced spending as well as the compensatory tighter monetary policy has to ensure that there is no new inflationary impulse from the shift.
Finally, from a portfolio perspective, we remain conservatively to very conservatively positioned on duration risk across a host of our fixed income funds. We don’t yet get a sense of any near-term equilibrium either from evolving policy iterations locally (no criticism here, just an observation that this remains a work in progress), or the ongoings globally. While bond yields locally have risen, they don’t seem to be offering adequate cushions yet if the current global themes as described above were to continue. As always, this reflects our current view and thinking and this may change at any point going forward.
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