To recap, a useful lens with which to view India’s bond market till very recently has been that of the so called “impossible trinity”. Thus, weaker capital flows leading to currency pressures have effectively led to tightening of domestic financial conditions reflected in rising yields, despite rate cuts and benign RBI commentary. In our view, weak capital flows despite sound domestic macros in turn have been owing to:
- Higher global rates
- Alternate themes attracting global capital, chiefly AI.
- More recently, the West Asia war.
There have been 2 recent developments that are unequivocally positive in this context:
- Focussed recent measures from government and RBI (including the subsidised FCNR deposit scheme and government bond tax exemption for FPIs) which are material both in form and intent shown. Thus, they will for the time being alleviate pressure from the currency and considerably ease funding stress from balance sheets. Foreign fund flow into government bonds is already improving, likely partly reflecting the more constructive near-term rupee view and, significantly, the tax exemptions on government bonds. Importantly, policy makers have voiced keenness to continue exploring additional measures to strengthen capital flows into the country. This is important because the FCNR window constitutes temporary funds flow from abroad which will reverse when the deposits mature. Therefore, the time that this provides must be utilised optimally to ensure that more sustainable capital flow measures can be put into place.
- With the cessation of war, oil prices have corrected significantly, with brent almost exactly back to pre-war levels at the time of writing. This so far is contrary to commonly held views that the floor price on oil will move higher even after the war, given the need to rebuild inventories. There has been similar relief in urea prices as well. These have led to expectations on both inflation and government subsidy bill being scaled down.
From a monetary policy standpoint, these developments push further out any expectation of rate hikes with the market currently debating whether any hikes at all will be required or not. We are somewhat open on this: we don’t except any move in August but for now aren’t sure whether any hike expectations should be altogether dispensed with. To be clear, however, whether these hikes eventually come or not currently has very little bearing on our portfolio strategies (more on this below). This is because almost nothing barring the very front end is being priced off the repo rate currently, even after the recent fall in yields. Thus, one can be constructive on the market purely basis the 2 large developments outlined above without immediately deciding on rate hikes. Suffice to say that should these benign developments hold 1> we don’t expect more than 50 bps of hikes in total, 2> we don’t expect them to start before October.
For more sustained relief on market yields, however, we may also need global rates and the AI theme to start to cool off a bit. Here the news is somewhat mixed as of now. On the one hand, the first Fed meeting of the new Chair was perceived to be hawkish and has led to some repricing higher in US rates as well as in the dollar index. On the other, and without claiming any iota of expertise in the matter, we note that the AI commentary seems to be turning a bit more mixed lately. Thus, the costs of build out and consumption, alongside rising supply of market issuances (both equity and bonds) to fund capex, seems to be gaining more attention than before. We will watch with interest if the power of this theme on global capital flows abates somewhat so that some alternate investment destinations can also lay a bit of claim.
Portfolio Constructs
With near term risks abating, we remain constructively positioned across portfolios. Our preference remains for up to 3 – 4-year points on the corporate curve and 14 years and beyond on the government bond curve. With our own view changing on quantum of rate hikes, and with a gush of liquidity waiting around the corner from FCNR flows, we are now comfortable with the idea that yield curves may be steeper than what we thought before. However, the portfolio construct as described here allows for this, while ensuring enough duration participation via the government bond curve. Looked at differently, the two casualties during the worst effects of the impossible trinity have been corporate bond spreads and term spreads, the latter specifically for the government bond curve. Thus, positioning at front end points on the corporate curve (including bank CDs) and back-end points on the government bond curve allows participation in both themes as the respective stress unwinds. Even after the recent fall in yields, valuation across a host of market rates remain comfortable considering the developments as described above. At the time of writing, and while retaining full flexibility on potential future changes in views and portfolio constructs, we are quite comfortable running overweight market risk while monitoring unfolding developments both on global macros and India policy.
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