1. The defining feature of the post Covid global macro cycle was the staggeringly large fiscal and monetary stimulus administered in the major developed market (DM) economies. This in turn lifted global growth, but only temporarily. This year was anyway supposed to be the year where most of this effect faded as the incremental fiscal expansion faded and monetary policy normalisation commenced. The chance for this transition to proceed smoothly and for economies to fall back towards underlying ‘trend’ growth rates was disrupted on account of two inter-related developments. First, the Russia-Ukraine escalation provided a large commodity shock. Second, and partly because of this shock, many DM central banks are now in barely controlled panic on concurrent inflation in their respective economies. This has led them to embark upon a very rapid normalisation cycle. The word ‘normalisation’ here is used loosely. Taking the case of US for instance, the forecasted Fed funds rate in this cycle is higher than what is deemed as long term neutral by a good 100 bps or so. Also, the pace of change matters as well since economic agents then receive this as a shock and accordingly are at risk of responding in an exaggerated manner. As an example, mortgage rates in the US have climbed more than 250 bps in a matter of months which is already telling significantly on the housing market. Further, it is quite rare for central banks to plan for such aggressive rate hikes in the face of collapsing consumer sentiment.
2. The recent shift in Fed communication is thus noteworthy. Seemingly, from trying to ‘soft land’ the economy while controlling inflation, the Fed now appears to be focussed exclusively on inflation while acknowledging that soft landing may not be controllable owing to external factors. While this reflects the scare on inflation currently, the commentary could also partly be unavoidable given that any dilution here will in turn incrementally ease financial conditions. The Fed cannot afford that since it is doing most of its tightening today via market expectations, a fact that it has well acknowledged. At any rate, the ‘pressure valve’ for now can only be released in two ways: One, there is a cessation of war and commodity prices back down. Alongside, markets will also unwind part of monetary policy tightening expectations, thereby providing a double lift to sentiment. Two, and this for now seems the more likely course, there is ‘breakage’: that is, the growth downturn has to bring down inflation. Signs of this are already visible, in concurrent economic data, credit spreads, market’s view on path of policy rates beyond the first year, and in commodity prices. This is why we think that further upward surprises in US inflation, if they come about, may now start showing as yield curve inversion. This is because markets will then assign a larger probability of Fed overtightening.
3. Consumer sentiment has crashed almost across all DMs which is reflected well now in discretionary goods spending with some tentative signs of services consumption slowing as well in a few large geographies. While accumulated savings from past fiscal transfers is a buffer and a potent argument for consumer balance sheets being in much better shape, this may still nevertheless be consistent with a discretionary consumption slowdown. This is because the propensity to hold on to those accumulated savings may be larger with visibly deteriorating economic prospects and notably negative real income growth rates. Even in China consumer sentiment seems to have suffered severely. This could be a result partly of the slowdown underway for some time and partly owing to recurring lockdowns on Covid. Here again, while re-openings and policy easing underway will no doubt lead to some economic traction starting the quarter ahead, the damage to consumer sentiment may be more long lasting. This may tell on the pace of normalisation in discretionary spending.
4. An added dimension here, from the general perspective of the goods economy, is what is commonly referred to as the ‘bull-whip’ effect. In the post Covid outbreak period goods demand shot up both owing to better purchasing power on fiscal transfers as well as on inability to spend on services due to mobility restrictions. Combined with supply congestions it led to product shortages. This in turn caused manufacturers to increase ordering up their production value chains to not just cater to current demand but in anticipation of future demand as well given the lags now in production. With now a consumer slowdown underway, this bull-whip may be reversing for the goods economy. As a first tell-tale it is showing in excess inventories in certain geographies. This in turn slows down ordering up the value chain thereby completing the trajectory down of the bull-whip with consequent downward pressure on prices.
5. As an interesting aside, and using US as an example, the value of the dollar hasn’t been challenged despite visible economic mis-management leading to such a large inflation scare. So while theories continue to abound around the status of ‘king dollar’ changing, the real world evidence so far doesn’t seem to suggest any imminent threat. In fact it is probably the same confidence coming from printing the reserve currency of the world that led the US particularly (but many other DMs more generally) to effectively think about the size of their post-Covid response in virtually limitless terms. Put another way because they could afford to do it in financing terms, they probably did it. The repercussion instead came as a severe domestic economic issue in the form of runaway inflation. Many emerging markets (EM) on the other hand, including India, were quite aware of their external constraints to begin with and accordingly modelled their policy response. This is now reflected in a lesser persistent inflation problem in these economies and will therefore not require as severe monetary tightening (more on this later).
6. That said, it is possible that the US itself is inching closer to an (uncomfortable) equilibrium. Real yields upwards of 3 years are now positive and even more so than they were on the eve of the pandemic. This has happened both from medium term inflation expectations falling and nominal bond yields rising over the past few months. One can potentially hazard an interpretation that this should signal some sort of tentative stability to bond yields. Another way to look at this is that market pricing on peak Fed funds rate in this cycle is now lower than what the FOMC’s last dot plot suggests. Again somewhat tentatively, one can hope that this is a case of market leading the Fed once more (just as it did on the way up on rate hike pricing).
7. India’s MPC recent commentary, as captured in minutes of the last policy meet as well as from other sources, seems consistent with a less aggressive residual tightening cycle than what current market pricing reflects. As a starting point, one has to note that there are divergent views now in the committee and hence one has to evaluate the balance of probabilities basis what a minimum of 3 members is likely to support. An assumption here is that Dr. Patra represents the analytical view from RBI even though individual members may have their own overlays. With this in place, we proceed with the following observations / analysis: ‘Real’ policy rate seems to be getting generally defined as nominal rate minus 1 year ahead forecasted inflation. This at least seems true for Dr. Goyal and Dr. Patra (and by assumed implication with RBI). Now in all probability 1 year ahead forecasted inflation will be lower than the RBI’s forecasted Q4 FY23 inflation of 5.8%. Dr. Goyal may even be signalling that in her view we are done with rate hikes for now (“the one-year ahead real rate must not be more negative than -1%”). Dr. Patra seems to be emphasizing returning to target inflation over a period (“within a two-year span”) and has expressed a hope that “required monetary policy actions in India will be more moderate than elsewhere in the world”. Put another way, Dr. Patra seems more patient to allow for the disinflation forces to run their course, provided the direction now is lower. This seems somewhat different from many DM central banks who seem to be wanting stronger near term confirmation that the monetary medicine is working. Finally, RBI member Dr. Ranjan has made an important point: “With more than 40 per cent of the total floating rate outstanding loans linked to external benchmarks, the degree of pass-through to actual lending rates has increased and this would strengthen monetary transmission in the current cycle. The inherent framework of the EBLR regime which enables quicker and larger transmission to lending rates coupled with banks’ propensity to pass-through policy rate changes to lending rates rather quickly, particularly during tightening cycles, may have to be factored to achieve the desired outcome during the current tightening phase”. While he caveats this with the risk factor on inflation trajectory, this nevertheless suggests him supporting more measured tightening once a certain level of normalisation is achieved.
8. The above, if true, is consistent with our own view that though normalisation is being undertaken speedily, peak overnight rates in this cycle will nevertheless be below 6%. Two additional concerns need addressing though. First, we don’t think RBI has been ‘behind the curve’ and thus we also don’t think it now needs to overcompensate. India’s total fiscal and monetary response post Covid was much more modest and RBI had started normalising policy much quicker. This was particularly reflected in the management of its balance sheet but can even be considered from a rate hike perspective. Suppose it had been ‘ahead of the curve’ and started hiking the effective overnight rate (from 3.35%) in October itself. Even then it may not have gone much higher than 5.15 – 5.25% by August this year; which is likely to be where it will be in any case. The only difference is that now RBI had to execute a pivot with consequent additional volatility to markets. But the macro-economic consequences in the two paths may have been very similar to one another. The second argument is around maintaining some sort of a rate differential to US as the latter hikes aggressively. However, this one always rests on trickier legs when you don’t have a domestically induced visible economic imbalance. For one, the rate differential also has to account for the new inflation differentials in play. Additionally, market yield differentials between US and India aren’t very far from their average over the past 5 years. Further, the quantum of rate hikes required to stabilise the current account quickly or to make rupee speculative costs prohibitive will require an extraordinarily large growth sacrifice. This in turn may further accelerate portfolio capital outflows on accentuated growth concerns. 2013 was very different since the problem then was a domestic imbalance basis an overly stimulated local economy. The imbalance merely got revealed earlier than it would have owing to the so-called ‘taper tantrum’. Even then, what finally stabilised the rupee was the deposit scheme for attracting inflows more than the emergency rate hikes. The comparison to current conditions shouldn’t ordinarily be made at all but is nevertheless discussed here for the sake of completeness of discussion.
9. A recent development that supports inflation peaking off is the noticeable correction in a host of commodities outside of oil. This seems to be an expression of rising growth concerns around the world; even as the threshold for DM central banks to slow their rate hikes is considerably higher still. Most notable here probably from the standpoint of our CPI is the significant fall in international edible oil prices over the last month or so.
10. Finally, some Indian bond market dynamics. We continue to think that over the next few months the market will probably do two things: One, take out some of the ‘excess’ rate hike expectations currently in play. We’ve made the case for this before as well as in the analysis above. Two, build in more bond supply yield premium in longer duration segments (10 year onwards). This needs further explanation. Fiscal consolidation for the centre is going to be a gradual exercise over multiple years. There was a chance to make a ‘down-payment’ this year given that nominal growth rate for the economy (and hence for taxes) is going to look very strong. However, the government had to step up revenue spending as a shield against the extra-ordinarily large price pressures that are abounding. Next year, some of these spending items will subside but so will nominal growth rate. In a slowing world it may anyway become that much more difficult to do any meaningful fiscal consolidation as a policy choice. Further this is happening as annual bond maturities are substantially large over the next few years. All of this means that longer duration needs to have a yield premium in relation to short / medium tenors. We find this as inadequately reflected in the current 5 to 10 year spread (5 year to 10 year and longer is too flat), and hence maintain our preference for 4 – 5 year government bonds.
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