The last month has been challenging for emerging markets. While some of these have had individual idiosyncratic issues, a renewed strength in the US dollar seems to be behind the general recent aversion to emerging markets. That strength itself is being attributed to various things: Growth prospects in the US versus other major economies seem more robust again as traction around the fiscal stimulus gains ground. This comes at a time when data from the other major economy, Euro zone, has slowed noticeably. Also, there has been a renewed sharp rise in US front end rates thus further boosting appeal for long dollar trades. Finally, there has been a further escalation in certain aspects of geo-political risks with the most recent trigger being US walking out of the Iran nuclear deal.
This emerging market aversion has led to some of the more susceptible economies struggling with the age-old problems of trying to protect their external accounts. As an outlier example, Argentina has had to undertake massive hikes in its policy rate since April. As an instance of how fortunes turn, this is the same country that had a 100-year bond issuance trading without a worry in the world till end of 2017. The worries for other markets are not as severe. But they still do exist. Indonesia for instance seems to be ‘in the middle of preparing firm monetary policy measures’, prioritization stabilization to ensure market confidence and macroeconomic stability is maintained. Indonesia doesn’t seem to have a macro issue per se. However, its bond market is heavily owned by foreign portfolio investors (FPI) who may be in search of some confidence from the central bank with the current global volatility underway.
Don’t Think Twice
The above is meant to flag a global theme underway currently, and not necessarily to draw parallels with India. However, this does mean that till the environment for USD funding stabilizes somewhat, India also has to heighten focus on macro stability. The rupee has been under pressure lately and has depreciated rapidly since early April. Over this period, it has also underperformed a lot of other Asian currencies. India is of course a deeper market and reliance on FPI money is quite miniscule. However, as discussed here before (please refer “You Want It Darker: A Bond And Macro Update”, dated 18th April for details) India’s basic balance has deteriorated over the past few months. Also, despite the rise in the US dollar, oil prices have risen sharply owing to geopolitical reasons. India’s sensitivity to higher oil prices, first on current account but then also on fiscal and CPI, is well known.
The minutes of the last MPC policy meeting made clear that there is a rising probability of MPC turning stance from ‘neutral’ to ‘withdrawal of accommodation’ in the June policy. Our base case has been for this to happen followed by an actual hike in August or October (please refer “Communication Breakdown? MPC Minutes”, dated 20th April for details). However, with the recent further rise in oil prices and incremental pressure on the INR, we acknowledge here the possibility that the MPC brings its action bias forward and actually hikes in June itself. For Deputy Governor Acharya, oil prices and assessment of growth recovery and hence output gap have been the two main drivers. In the last minutes he showed significant comfort with the growth outlook. Indeed, he assessed near complete closure of output gap basis his personally preferred ‘finance-adjusted measure’. Whereas, oil prices are more than 10% higher than the date of the last policy. Also the rupee has depreciated around 3.5% since then. Given these, it is possible that Dr. Acharya may be persuaded to cast his vote for an earlier hike. With two out of three RBI members in the MPC swinging for a hike, it may not be a tall ask to convince two other members to sway in this direction.
It must be emphasized that what is being discussed here is pure speculation, since it is always difficult to predict individual decisions. What matters more from investors’ view point is whether this has any implications for fixed income strategy. There are two points of relevance here:
1. An earlier hike may actually be desirable given the global backdrop. Financial markets (and, indeed, most other aspects of life) are largely about perceptions. Thus a ‘preemptive’ MPC already moving to address evolving inflationary risks may be perceived well by external watchers. Bond yields are anyway not getting priced off the repo rate. Term spreads even at the front end (2 to 4 year rates on government bonds and almost everything on corporate bonds / money markets) have no meaning and are at stress levels. Instead the problem is one of demand versus supply which in turn has caused a complete log-jam in the funding market. Hence, notional rate hikes at this juncture will have very little impact on bond yields at the front end, provided the accompanying communication is handled well and doesn’t disrupt forward rate expectations. Whereas if the MPC is deemed preemptive and, alongside some stabilization in the external environment, this stabilizes FPI demand for our fixed income to some extent; it may actually turn out to be beneficial for bonds.
2. What matters for investing today is not so much when the MPC starts to hike, but rather how many rate hikes the cycle is likely to have. This is because term spreads from current repo are at stress levels and market is already discounting a 75 bps odd hike in repo. To that extent it is a strange cycle to begin with. The cycle is also strange from a standpoint that the economy is far from overheating yet. Thus output gaps, even as per RBI, are only now closing. Credit growth is only just rebounding. And CPI is still currently very well behaved. Also, the recent severe tightening of domestic financial conditions (spike in yields and funding market grinding to a halt) is bound to have an effect on growth down the line. Given this, we expect this rate hike cycle to be very shallow and estimate that the market is more than fully discounting what it’s likely to be. The only caveat here is a severe tightening of global financing conditions and / or a disruptive further rise in oil prices. Hence it is not the hikes in repo rate that should worry market participants even if a beginning is made in June, given the expectation of a shallow cycle and the upfront discounting already in place. Further, if RBI likely continues OMO purchases alongside whatever rate hikes are to come, it may actually turn out to be a better outcome for bond markets insofar as this addresses liquidity and the current demand – supply imbalance for bonds.
Conclusion (It’s Alright)
The bond market today is totally disconnected with the level of the repo rate. Hence, even if the MPC chooses to hike in June as a preemptive move to signal seriousness on CPI targets, this should be fine with the market. What really matters is that the accompanying communication is handled well so that the market view remains of gradualism. Indeed, basis local factors alone, the MPC may very well choose to wait longer. This is especially so as markets have already done RBI’s job more than adequately. Financial conditions have tightened significantly and will already likely impact growth down the line. However, the recent turn in global events may trigger the earlier move. Either way what only matters is that forward expectation remains of a shallow cycle. Also, RBI has announced the first OMO sooner than expected when system liquidity is still positive. This seems a preemptive move, and also a signal for bonds (please refer “RBI Fires OMO”, dated 7th May for details). Given higher currency leakage and shrinking balance of payment, the RBI will have to buy more than INR 1 lakh crore of bonds in the year ahead. Should it spread these evenly, then OMOs will likely continue. This is eventually much more meaningful for bond yields than the level of repo rate. Preference should remain for front end strategies (up to 5 years) given attractive valuations, a very flat curve, and no macro reason to buy long duration.
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