RBI/MPC kept policy rates on hold as widely expected and kept stance unchanged. That said, there was a decided shift in communication this time around. There is acknowledgement that inflation is markedly undershooting projections post GST cut as well as is tracking more or less at target for the next financial year as well. Growth estimates have been raised reflecting the strong outturn on real GDP thus far, but risks are mentioned from global uncertainties. Most importantly, the room for further easing is explicitly acknowledged even as the MPC has chosen to wait for now for monetary and fiscal easing conducted thus far to play through. Finally, two external members were of the view that stance be changed from neutral to accommodative.
Revised macro projections are as under:
Expectation Restored
It will be remembered that the abrupt change of stance in the June policy had effectively severed the expectation channel for markets. This, alongside incessant supply of duration lately via SDLs, has led to market sentiment getting very subdued. Thus, even with falling inflation, a relatively low funding rate, and slowing credit growth one has seen across the board pressure on bond yields. Note that what started as a problem of long duration supply only has recently morphed into a much wider issue of generalized apathy towards buying bonds. This has exhibited as pressure also on the 5 year and around segment of the yield curve, which is traditionally a favorite trade in an easy rate cycle with slower credit growth. Indeed, this has allowed us to go overweight the 6 – 9 year segment in our active duration bond and gilt funds at relatively very attractive valuations, in our view.
With today’s policy market expectation for the next rate cut will be revived. This should bring back interest in the bond market especially given the recent sell off in the hitherto preferred segments of up to 5 – 9 year maturities. These offer reasonable participation and are very well poised from a valuation standpoint. We expect the yield curve to steepen going forward as though even long bond yields are now capped, the floor on these may also have moved higher. Even with the 5% supply shift from this segment for the second half GOI calendar, SDL supply remains large and offers a wide variety of options for pension/insurance investors not to have to chase down long term government bond yields beyond a point.
Also, if growth headwinds owing to external factors were to escalate, then this will invite both a monetary policy as well as a fiscal response. Both are likely to be calibrated in our view, ensuring continued macro-economic stability as has been the endeavor of macro-policy in the past. That said, it is the direction of travel that matters for the market and incremental calibrated support from both fiscal and monetary policy will likely translate into incremental steepening of the yield curve. A point of note here: the fiscal framework moves next year to targeting medium term debt to GDP from annual fiscal deficits till this year. This will allow some expansion in the deficit target for FY 27, should the need arise, while retaining full credibility on fiscal management. A statement that stands out for us from the Governor today is this: “As India strives towards achieving Viksit Bharat by the centenary year of its independence, it would need the coordinated support of fiscal, monetary, regulatory and other public policies to attain its goal.” While rates were held today, the RBI has undertaken regulatory easing to facilitate better financing in the system.
All Things Steep
In our view, it is largely a myth that term spreads are particularly higher at the long end of the yield curve. As at time of writing, 5 year to 1 year is approximately 60 bps, 10 year to 5 year is 40 bps, and 30 year to 10 year is 60 bps. Thus almost everything to everything else is steeper and the long end doesn’t particularly stand out anymore for its steepness. It would still make sense for real money to participate at the long end if the view were of a very substantial fall in yields going forward. However, while we remain constructive on the market and deem any sort of ‘end of cycle’ plays (like shifting to pure ‘carry’) as being premature, we also think that the phase of ‘blunt’ participation via maximizing duration is behind us. We expect yields to fall, but in a more measured fashion, and the yield curve to steepen as this happens. Thus ‘optimizing’ duration via appropriate positioning on the yield curve is required in our view, which is what we are doing in our active duration funds.
Conclusion
The policy today was consistent with our view for dovish commentary leading to a last rate cut, most likely in December. The recent tweak to the central government borrowing calendar isn’t a game changer for portfolio strategies and we expect the yield curve to steepen into the next phase of the rally. Our active duration bond and gilt funds are overweight 6 – 9 year government bonds, and most of the rest is up to 12 year maturities. In our view, this should enable optimal participation in how we expect the shape of things to evolve. We expect SDL spreads to remain high as H2 should bring as much gross supply here as from central government bonds. This will also keep corporate bond spreads relatively high. Therefore, we continue to prefer government bonds for ‘beta’ plays even in our intermediate duration funds for now.
Investors have been largely on the sidelines for the last few months, especially after heightened market volatility since June. With the policy today applying the proverbial soothing balm, and with bond valuations having cheapened substantially, appropriate strategy selection basis investment horizon and appetite for volatility may now be considered again.
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