The December monetary policy review contained a somewhat more dovish than expected assessment of the growth-inflation trade-off (https://idfcmf.com/article/6431 ). Thus the dominance of growth considerations persisted despite the recent strong pick up in momentum whereas a sticky core CPI trajectory didn’t seem to overly perturb the commentary. The subsequent minutes of the meeting released recently provided some analytical context to this. Side by side, the process of normalization continues in line with the Governor’s guidance statement in the December policy around the auction mechanism being the predominant tool for liquidity absorption by January. RBI has started to supplement the longer variable rate reverse repo (VRRRs) with very short ones now, presumably aimed at improving the success rate of such operations and thereby bringing down further the amount parked under the overnight reverse repo rate window. Finally, and somewhat curiously, RBI seems to be selling bonds in the secondary market. Although the weekly numbers are somewhat modest, they nevertheless cumulate to a relatively significant amount. This is especially as the inherent appetite for bonds in relation to supply remains somewhat constrained as reflected in a stubbornly steep yield curve. In this note we dwell on these dynamics and conclusions for portfolio strategy.
1. A Dovish Assessment: RBI’s macro assessment, proxied here with impressions derived from the analytical framework presented in Deputy Governor Patra’s minutes, remains conclusively dovish. The broad theme seems to be: 1> Despite recent growth pick up economic activity generally has only approached 2019 levels which itself represented the culmination of a multi-year growth slowdown. Additionally global growth momentum seems to be slowing and new Covid concerns have risen, thereby threatening to put paid to what is already an incomplete recovery with substantial scarring from the pandemic slowdown. 2> Inflation is a worry for now, especially with some pass throughs and price hikes still pending. However, this will likely subside by second half of 2022 as the so-called ‘bull-whip’ starts moving in the reverse direction for global supply chains. The first signs of this happening may already be there with some build up being seen in product inventories in manufacturing surveys. 3> There is stated inclination to ‘take guard and resume battle readiness again’ in the face of the new virus variant.
In the realm of preferences, Dr. Patra now conclusively represents the dovish end. And unlike what a cursory reading may suggest, the hawkish end (from a bond market standpoint) is probably not external member Prof. Varma but actually Dr. Goyal in our view. This is because all Prof. Varma wants is for ‘effective money market rates’ to be raised to 4%, and is nudging for a change in stance to express the desirability of such a scenario (since MPC can’t determine the reverse repo rate). He continues to believe that 4% will represent an appropriate setting given the current macro-economic context and isn’t opining on rates beyond that. To be fair to RBI, this is what it seems to be anyway trying to do (more on this below) even without a hike in the reverse repo rate. Dr. Goyal, however, wants measures to reduce durable liquidity (presumably beyond the VRRR tool). This will entail things (OMO sales, CRR hikes, etc) which will be deemed much more damaging by the market. Dr. Saggar also expresses a desire for more active liquidity management but, at least in our reading, doesn’t explicitly call out for tools to reduce durable liquidity (hence the ongoing VRRR program may conceivably satisfy his ask).
The takeaway from the above analysis for us is this: there is absolutely no line of sight on when the collective judgement of the MPC is looking at a level of overnight rate beyond 4%. Thus, while it is prudent to pencil in some expectation of an eventual repo rate hike, it is difficult to assess when this would happen. The best guess, reading the minutes and in context of the more recent onslaught of the Omicron, is that this should happen not in April but more likely in June. February will likely present an optically poor policy to do anything at all (given the ongoing virus wave with consequent incremental impact on high contact services over and above the already somewhat cautious growth assessment from RBI) and even the normalization of the corridor may have to await the April policy. An additional potentially dovish but somewhat unquantifiable factor is Dr. Patra’s reference to battle readiness again and what this may entail. On the other hand, a bearish trigger could be more permanent measures around liquidity (as expressed by Dr. Goyal) which would amount to a reasonably disruptive signal to the market.
2. The VRRR Tool: The adoption of VRRRs is consistent with the move back towards the revised liquidity management framework of early 2020 (https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid” =49343 ). The original framework was in the context of repo – reverse repo spread of 25 bps. However, since the VRRRs are currently being used with a much wider 65 bps repo – reverse repo spread there are multiple outcomes that need assessment. One, the overnight rate available to market participants that don’t have access to the RBI window is on average significantly lower (and subject to significant intra-day and day-to-day volatility) than that available on average from RBI. Two, as a result of this, near term money market rates are at levels more consistent with 3.35% as the operative overnight rate. Three, despite a significantly wide corridor (and hence substantial ‘penalty’ for parking surpluses under the overnight 3.35% window when the VRRRs are available at close to repo rate) banks are still using the overnight window to a significant extent. This begs the question: Won’t the usage of VRRRs become lower when the corridor is narrowed (as penalty to park in the fixed rate overnight window reduces)? This question in turn muddies to some extent expectations around both the timing and quantum of corridor normalization ahead.
On the other hand, RBI may be willing to live with these deficiencies as a trade-off for retaining flexibility with the extent of usage of the VRRR tool should the necessity arise to dial up the dovishness. Thus, as an example, it can bring down the weighted average rate offered to banks on their surplus liquidity by merely reducing the amount of VRRR on offer. This is of course pure speculation but should this happen, to the extent that market participants will look at this as a temporary measure, it isn’t clear whether it will contribute to incremental transmission. In short then, money market rates will likely remain quite volatile till some of the points raised here get settled.
3. Open Market Sale of Bonds: RBI seems to be selling bonds in the secondary market for the last few weeks, as per weekly data released by it. While the weekly numbers are reasonably moderate, they have nevertheless chalked up to a reasonably hefty more than INR 10,000 crores cumulatively since mid of November. If continued, or indeed stepped up, this is a significant bearish trigger for the bond market. Our long held view is that it isn’t the quantum of effective rate hikes (or peak effective overnight rate in this cycle) which is the major issue for the market, but rather the absorption of bond supply. This has informed our choice of what maturity bonds to buy to benefit from curve steepness (3 to 6 years maturity broadly) as well as our caution with respect to long maturity floating rate bonds. Given an expected gradual path of fiscal consolidation and large bond maturities over the next few years, the gross bond supply is expected to be beyond the orderly absorptive capacity of the local system in our view. This would mean that either RBI or foreign investors (via bond index inclusion) will need to be accounting for some part of the bond demand. In fact the primary reason we haven’t been that enthused with the bond index inclusion prospects is that absent said inclusion RBI will have to be in play as a bond buyer and with inclusion it will be foreign investors and not RBI. Either way, however, be it purchase of bonds or forex (the latter in the event of foreign flows on bond index inclusion) RBI may be forced to create more liquidity via balance sheet expansion, ceteris paribus.
Thus the only stable equilibrium, or path to orderly evolution of the yield curve, that we can envisage is a continuation of the so-called ‘twist’ operations including variations of the same. The end effect of such an operation is that market gets help with duration absorption whereas there is no immediate addition to system liquidity. We can envisage this running in a variety of ways in the year ahead: 1> Ordinary twist where RBI buys longer duration and sells very short ones (say up to 1 year maturity). 2> Longer term VRRRs combined with outright OMO bond purchases (sounds counterintuitive and granted quite cumbersome in execution, but may be useful if RBI starts running out of relevant short duration government bonds to sell to the market). A variant of this could be to use market stabilization bonds instead of VRRRs on the second leg. 3> Forex purchase on foreign inflow into bonds then neutralized with shorter tenor liquidity absorption tools like mentioned above (in this case the two operations will not occur as a pair).
It is to be noted that in all of these variations, the local market is being helped with absorption of duration. What in our view is unsustainable is not only the market not getting any help with duration absorption, but RBI actively adding to bond supply to market through its permanent liquidity operations. Put another way, the policy imperative is to normalize the exceptionally low level of overnight rate over a period of time while ensuring that the transmission up the curve of this process is quite muted given the already large steepness currently. In our view, this can only be attained via twist or variants as described above. Outright sale of bonds to the market, or even leaving the market entirely to its own devices without any intervention whatsoever, risks the running out of risk appetites eventually even in context of what is already a very steep yield curve.
Putting It Together
The above analysis yields conclusions consistent with what we have made before (https://idfcmf.com/article/5730 and https://idfcmf.com/article/6175 ). The main actionable conclusions we had arrived at were:
- The bulk of the playable curve flattening will be between 1 and 5 years and not 5 years versus higher duration points. This is especially true given the roll down available in the 5 year which isn’t the case for 10 year and 15 years (at least not discernibly for the next few years).
- Hedges aren’t cheap (including interest rate swaps and floating rate bonds).
The progression of the market has thus far been largely consistent with the above conclusions and we continue to think that these remain relevant going forward. It is also to be noted that 5 year to 10 year isn’t all that steep as may be generally thought of. 5 year now corresponds with 2027 maturity. While we don’t have a benchmark bond in that year, we do have semi-liquid ones. As an example, and this bond is part of our holdings in index as well as bond and gilt funds, a May 2027 government bond is approximately at 6.15% at the time of writing while the outgoing 10 year (9.5 year now) yields 6.49%. Given the duration supply ahead (already kicked off with a Q4 state development loan borrowing calendar that is roughly twice the actual borrowing by states in Q3), we would think this spread is actually quite attractive in favor of 5 year. Put another way, we wouldn’t expect this spread to compress sustainably going forward (especially after accounting for roll down benefits on the 5 year).
The above analysis and conclusions continue to inform our choice of portfolio construct. We are heavily overweight 4 – 5 year government bonds in our actively managed bond and gilt funds. We had described earlier the reasons behind exiting the aggressive cash call that we had taken during part of November and December (https://idfcmf.com/article/6519 ). Since then global bond yields have risen somewhat, but this seems driven by a broad-based risk-on rather than a further repricing in rate normalization expectations. Reflecting this, the rupee has actually strengthened notably during this period. Further, while worries on the trade account and on core inflation remain, we must acknowledge that partly basis the actual outturn for November, our near term CPI forecast has undergone a meaningful downward revision. Finally, the minutes of the last policy as analyzed above and especially with the context of the ongoing Omicron wave, argue for a later repo rate hike than what we were thinking of before.
All told and given the steepness of the curve, only the prospect of sharp rises in yields over relatively short periods of time call for substantial cash calls. With the Fed pivot largely digested for now and given local dynamics as described here, we have no visibility on this happening in the near term (especially after a reasonable adjustment done in bond yields over the past couple of weeks). Risks to this expectation include 1> The giving up of local market’s risk appetite for bonds on continued absence of (sporadic) positive intervention from RBI. 2> A further incremental hawkish pivot from the Fed that disturbs market’s current rate hike expectations meaningfully.
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