Despite the mammoth bond supply being given on a weekly basis and the huge quantum that still lies ahead, the bond market’s equilibrium over the past few months has been basis the following factors:
- Proactive easing by RBI and the assurance that more will be coming basis the unprecedented ongoing hit to growth.
- The expectation of continued unconventional measures under a commitment that the borrowing program will be managed non-disruptively.
- A strong commercial demand for bonds given the collapse in credit growth and the abundantly surplus liquidity environment.
As a result of these factors, the bond market was largely holding its equilibrium despite RBI’s relatively light touch approach with respect to managing the borrowing program. Thus, apart from buying into treasury bills earlier and sporadic “twist” operations, RBI has largely kept away from directly supporting the bond market. Indeed, there have been no specific statements of intent made as well but for the general commitment around avoiding disruption and standing “battle-ready” with all tools at its disposal. It is thus largely the embedded confidence of the market in the RBI, alongside the lack of credit growth, that has kept the bond market stable.
A Break In The Continuum
Unfortunately, India didn’t have a very robust hand dealt to it in managing the macro-economic fall out of the ongoing crisis. Thus our growth was already weakening for the last few years, the lending system was experiencing its own pains, and the public sector deficit was already bloated. Given that the virus has endured and lockdowns have prolonged, the impact to growth if anything is now likely to be far greater than what was initially envisaged. This is well demonstrated by the observation that even into the fifth month of the fiscal year, we are still around 80% or thereabouts of pre-Covid levels of activity on aggregate. The government has been prudent so far in rationing its stimulus response, focusing first on sustenance and keeping a growth stimulus for later. This is because a stimulus would entail financing for undertaking activity. This channel would by definition not work if activity is being held back owing to the virus. Despite the government’s prudence so far, however, the load on the fiscal is heavy. This is partly owing to the starting point, partly since the fall off in receipts has been large, and partly because more stimulus will necessarily have to be forthcoming. A necessary condition for financing this is a well-functioning bond market, which is able to absorb the extra load while at the same time not begin to substantially unwind the mandate of transmission that monetary policy is trying to execute. Indeed, this had largely been the case till recently, owing to the factors mentioned above.
There are a few things that have come in quick succession since then. The market had started to develop some amount of impatience with the continued insistence from RBI in following a light touch approach. In particular, one hears that banks were quite keen for a hike in the “held to maturity” (HTM) for bonds in their portfolios. This would have allowed them to continue absorbing the bond supply without fear of putting capital at risk in case of erosion in the value of investments. Furthermore, the so-called twist operations also have been sporadic and for that reason have been of limited utility. To be fair, however, the recent policy still preserved the guidance on easing and (implicitly) on liquidity. But this was followed up by an ugly inflation print and the minutes of the monetary policy committee (MPC).
The Curious Case of The Hawkish Minutes
What has somewhat taken the market by surprise is that the minutes sound much more hawkish than the policy. To some extent this marks the difference between what may be individual views (which are captured in minutes) and what emerged as the collective (as written down in the policy). That said, the policy clearly established the dominance of growth in the current setting even as it admitted to looking for a durable reduction in inflation to ease again. However, importantly, it also acknowledged the availability of space to ease and didn’t condition the appearance of this space on a durable fall in inflation ahead. On the other hand, the commentary from some members in the minutes seemed to suggest a cross-roads from where the direction of policy itself could potentially be called into question.
While the discussion captures the honest view of the members involved, it has served to inflict one important damage: the powerful tool of forward guidance, that had been well-preserved post the actual policy, has now been blunted post the minutes. Although this is an unintended consequence of the minutes being published, one cannot help but wonder whether more care could have been exercised. Forward guidance is a potent tool that can be employed with great efficiency to incrementally influence financial conditions in the intended direction of monetary policy. However in the present case, and pending further action from RBI, this tool may now be working in reverse even as the MPC is still waiting to see the data resolve itself. Looked at another way, the intent expressed by the Governor of also wanting to wait for some time “for the cumulative 250 basis points reduction in policy rate since February 2019 to seep into the financial system and further reduce interest rates and spreads” now risks being defeated. To restore the working of the ongoing process of transmission, the RBI will now have to do more.
Strategy Update
We expect the relevant parts of monetary policy application (liquidity and borrowing support) to remain largely intact, even as the forward guidance tool has been somewhat compromised for now. We have expressed our detailed view on the CPI print before (https://idfcmf.com/article/2562), and therefore won’t go into this now. From a bond market perspective, while the RBI’s invisible hand presumably exists and the central bank should make good on its stated commitment to ensure smooth execution of the borrowing program, it is nevertheless very difficult to actively play this. This is because one doesn’t know what quantum of a rise in yields counts as disruption to the RBI, what is the lag entailed in its reaction even once disruption becomes evident, and what is the strength of the reaction that it will display when it acts.
Fortunately the extra-ordinary steepness in the bond curve throws up all sorts of interesting portfolio constructs. There are points on the curve (for instance in the 6 – 8 year segment on government bonds) where the carry versus duration trade-off looks very attractive. This is because most of the steepness in the curve is between the overnight rate and this segment, and the curve is then relatively flat for longer duration bonds. This provides significant protection for this segment of bonds and they can even withstand some rise in yields over a period of time and still return close to money market rates. We had tactically shifted to longer 13 – 14 year bonds over the past month sensing some stability in markets. However, recent events have led us to re-instate our over-weight stance in the 6 – 8 year segment in our active duration strategies. Fortunately, the recent underperformance in this segment (bear flattening of the curve) has helped us do this without paying a very significant cost for the rebalancing. As always, the construct can change basis evolving views.
On his part the Governor has tried re-emphasising the room available for policy action in a recent interview, thereby attempting to restore the forward guidance tool. This is consistent with his own assessment in the minutes as well as the official policy statement. Also, the growth draw-down is large and the fiscal response relatively constrained. Finally, the external account is our one significant macro strength today and provides adequate cushion to RBI to persist with a dovish policy for the time-being. For all these reasons, our view remains that the important current pillars of policy will sustain for the foreseeable future. The spike in inflation presents an interpretation problem for now and it remains our base case that it will not shift the narrative away from growth for monetary policy, despite throwing up higher average CPI prints for the year.
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