The last few days have been very noteworthy for global markets as well as for India. We received a shock Indian CPI print at last week beginning which has served to substantially take up average FY22 forecasts for most analysts. Importantly these are now anywhere between 40 – 100 bps higher than RBI’s latest assessment. Then the US Fed meet seemed to sound somewhat more cognizant of inflation risks than market was prepared for the Fed to acknowledge at this point. This was reflected both in the average inflation forecasts for FOMC members as well as their expected rate hikes down the line, in 2023. The outcome caused substantial (albeit fleeting) price action mostly as a result of market positionings getting mis-footed. Thus the dollar index climbed, commodity prices generally fell, US long end yields fell and short end yields rose; precisely the converse of most market positioning leading up to the Fed meeting. However, at the point of writing, markets have had cause to stand back, reassess, and somewhat realize that the underlying US monetary policy framework resulting in a deliberately ‘behind the curve’ Fed (as compared with previous tightening cycles) is alive and well and things seem to be settling back down.
After this we had India’s MPC minutes which were overall dovish and highlighted the predominance of growth concerns, consistent with the tone and action of the actual monetary policy review earlier in the month. However given the CPI print since the last policy meet, the minutes do suggest that at least 2 members of the MPC (one RBI and one external) will find it difficult to ignore the 6% plus prints on CPI. That said Governor Das and Deputy Governor Patra may have a somewhat higher threshold and may look for more persistence of inflation. At any rate, the underlying view remains that the normalization of policy path ahead will be gradual and stretched out over a longish period of time (more on this below).
How We Are Thinking About Portfolio Hedges
Whichever way one cuts it, it is hard not to conclude that prospects for bond market volatility have risen meaningfully owing to developments of the past few days and weeks. Apart from the ones discussed above, one has to pay heed to the way oil prices seem to be on a one way climb lately, even ignoring the generalized sell-off that had taken hold in many other commodities in recent weeks. Coming on top of an already large interpretational issue on local CPI, this does serve to further curtail degrees of freedom for RBI in maintaining the current aggressive level of monetary accommodation. So it stands to reason that one should be actively thinking about putting in place some defenses for risk management.
This in turn can be looked at in 2 ways: 1> outright cut bond positions and raise cash in portfolio, and / or 2> ‘pay’ swaps (OIS) against bond positions to reduce maturity. Since the release of the inflation data till yesterday market close, government bond benchmark yields of 5, 10 and 14 year maturities have respectively moved up by approximately 11 bps, 3 bps, and 7 bps (the modest movement at 10 year point reflects RBI’s largest focus there and the fact that market may no longer have any meaningful positions in that bond). In contrast yields on 2 year and 5 year OIS have moved up by approximately 31 bps and 24 bps respectively. This seems to reflect two things: One, the RBI’s very hands-on approach for now in managing bond yields has curtailed the extent of rise here. Two, market participants holding other bonds (non-benchmark government bonds, corporate bonds etc) haven’t been able to exit in desired amounts and therefore have used swaps to hedge some of the duration risk. These conclusions are further buttressed by the observation that spreads on semi-liquid government bonds have been rising over the past week amidst very thin volumes thereby disallowing meaningful exits on positions.
Of course, a third reason could very well be that market participants actually prefer paying swaps to cutting bonds, possibly under a view that bonds are under RBI’s protection whereas swaps enjoy no such privileges. It is this dynamic that needs exploring further.
The chart above tracks the spread of 5 year government bond over 5 year swap for the last 10 years. As can be seen this, the spread has reduced considerably since early 2020 and currently stands at a significantly lower level than its average over these 10 years. This shrinkage since early 2020 coincides with the RBI’s intent of assigning significant weightage to evolution of the yield curve as reflective of financial conditions in the system and its consequent interventions to therefore manage the yield curve. We have described earlier how this linkage has been an integral part of RBI’s framework (https://idfcmf.com/article/4807). The current bond-swap spread still reflects the overhang of this policy since RBI hasn’t had occasion yet to administer any modifications. However, over the medium term if there is one obvious stress point for India’s macros it is the elevated level of general government debt and the higher than usual annual issuances of paper that is likely to be in place for the next few years. More specifically, the annual supply of bonds is a worry with respect to the absorptive capacity for duration with local market participants. This imbalance hasn’t been felt so far in this cycle owing to the proactive interventions of the central bank under its financial conditions assessment framework. It is also part of our base case that such interventions will likely continue for the foreseeable future, even as RBI may resume pairing them with selling short term bonds (operation twist) or with more longer term variable rate reverse repo (VRRR) auctions. However, the intensity of such interventions will likely reduce as the central bank starts assigning a somewhat higher weightage to inflation risks even as it remains watchful for the durability of growth recovery post the second wave. Put another way, it will probably fall back into ‘orderly evolution of the yield curve’ mode signifying more tolerance for marginally tighter financial conditions than what exist currently. Over a longer period of time, it is possible that there is a further reduction in its intensity of bond interventions again consistent with its view on financial conditions then. It is also likely that at some point if credit growth starts picking up, RBI starts to de-emphasize the role of term spreads in assessing financial conditions.
Overtime there are 2 underlying themes that seem enduring for the bond market in our view: One, as discussed above there is an issue of excess supply of bonds which will start asserting itself as RBI dials back on its scale of bond interventions. Two, and this may be true for many other major central banks, RBI will likely have a long drawn rate adjustment cycle. This is also consistent with a view that even though the short term cyclical bounce may be strong for the local economy, it may take much longer for purchasing power and confidence to heal for the aggregate of Indian consumers.
Given the above, it is quite likely that from current levels the swap curve may have a shallower adjustment pending ahead when compared with bonds. This is because swaps are a much purer expression of expectations with respect to the future path of effective policy rates. To the extent fiscal deficits are wider, swaps will need to directly worry only about the inflation effects of this and how this may feed into RBI’s policy rate trajectory. Whereas, bonds directly get impacted by the supply of them as well that comes with wider fiscal deficits. Thus, and especially as we are starting with a very thin relative cushion as illustrated in the chart above, it seems to us to be a much better idea to simply cut bond positions and generate cash to attain one’s desired level of duration rather than relying too much on doing this via paying swaps (which may entail a lot of ‘basis’ risk overtime).
Looking at Portfolio Yields Dynamically
It is obvious that given yield curves are so steep, any move towards cash will start impacting portfolio yields. We had debated at length around the costs and merits of holding some cash in our note last week (https://idfcmf.com/article/4914) and won’t get back into it here. However, from an investor’s standpoint it is quite important in our view that portfolio yields be looked at somewhat dynamically. Thus after a 3 year bull run in bonds if the portfolio manager is creating some hedges and flexibilities that in turn are showing up as reduction in yield, then this may even be looked at as a source of comfort for investors. Similarly, if corporate / credit spreads have narrowed to unsustainable levels in some cases and the manager hence decides to move to more quality assets, this could be a move to protect against future risks to spread expansion even as it entails some dilution in portfolio yields of the current portfolio. Thus a static analysis of portfolio yields and choosing the highest of these for every category of funds may not optimize risk versus reward, especially at cycle turning points.
A Strategy Update
We had discussed in our last note the analysis leading up to our decision to raise cash levels in our actively managed bond and gilt funds. Events since then have further emphasized to us the importance of this flexibility and the need to have it in amounts that can significantly buffer us against market volatility. On the other side, the carry loss is all too present given the steepness of the curve. Also, the evolution of RBI’s normalization process has to be looked at on a continuum and is always subject to delays should the recovery get hampered again or the strength of it were to underwhelm. As always, this comes to a judgement call and basis this we had for now increased cash levels to approximately 45 – 50% in our actively managed bond and gilt funds as at 21st June 2021. As always, these as well as overall duration can change at anytime basis our evolving assessment of various factors.
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