The RBI surprised markets by announcing an INR 10,000 crores Open Market Operations (OMO) bond purchase to be held on the 17th of May. While most market participants would have anticipated bond purchases by the RBI in the current year, given shrinking core liquidity in context of sharply rising currency in circulation and a dwindling balance of payment (BoP), the timing of the announcement comes as a surprise. The expectation was for the purchases to be back ended rather than now. Headline system liquidity still remains positive and the bulk of currency in circulation rise should be over for the first half year of the financial year, if trends have reverted to pre-demonetization levels.
Our key takeaways from the announcement are as follows:
1. This constitutes the second intervention from the RBI in the bond market in the past few days. It may be remembered that the regulator had recently relaxed FPI restrictions to allow them to invest in shorter maturity bonds than the previous minimum 3 year restriction allowed. Admittedly, the initial effect of the circular has been less than desired. This is largely for 2 reasons: One, the global backdrop is not very sanguine for higher allocations to emerging markets like India. Two, RBI has stipulated that not more than 20% of total investments should be in less than 1 year securities. This requirement is being deemed as onerous to comply with and media reports suggest representations are on to ask the regulator to re-consider this. Nevertheless, the timing of the FPI circular modification was a surprise as well given that it came at a time of rising global volatility and more uncertain FPI flows. If anything, going by past track-record, one would have expected the regulator to turn more (not less) conservative with respect to FPI participation. However, given that it happened, we were inclined to think of it as a sign that the frozen state of markets today was beginning to get addressed by the regulator. We would thus consider the OMO announcement as the second, and likely to be more effective, intervention in the same direction. It must be reiterated that this is being announced when headline liquidity is positive and we are close to peak currency in circulation for the first half, given historical trends.
2. This also likely settles another question that had occurred to us: when MPC turns stance to ‘withdrawal of accommodation’, could the RBI then also have moved liquidity stance to ‘deficit’ (say, back to -1% of net demand and time liabilities of banks) from ‘neutral’ today? With the announcement of OMO it is clearer that neutral stance will likely be maintained by the RBI even when the MPC moves to ‘withdrawal of accommodation’ stance. If this is the case, then one should expect OMO purchase in excess of INR 1 lakh crore over the course of the financial year. Also, the RBI may very well choose to take a forward looking view on liquidity and spread these more evenly through the year. In this case, the current OMO announcement may very well be followed up with more over the next few months.
The announcement again underscores the fact that bond yields are completely disconnected with the level of the repo rate. Thus the RBI is moving to create additional liquidity (with headline system liquidity already being positive) when one of its representatives into MPC already wants a hike and another is ready to change stance to ‘withdrawal of accommodation’. To us, the measure is intended more to unfreeze the bond market with the attendant toll on corporate bond financing that it is unnecessarily taking. Indeed the spread between repo and even front end (up to 4 – 5 years, where bulk of corporate and bank borrowing happens) is at levels last seen in the financial crisis times of 2013; while volumes have shrunk alarmingly even at the start of the financial year. Given this, it should actually be irrelevant to the market if the MPC decides to hike the repo rate over the next few months; provided that these rates are few and far between. This is because as far as rates are concerned, repo rate could already be 6.25 or 6.50% and levels would still be decent. What really matters rather is that RBI persists in fixing the current broken nature of the market. In this context, media reports suggest that there may be some relaxations provided to the ‘held to maturity’ (HTM) limits of banks to accommodate for government bonds that have to be kept to meet the ‘liquidity coverage ratio (LCR)’ requirement. If done, this would constitute as another significant intervention from RBI into the bond market, and would come as a big relief especially to public sector banks who have faced substantial mark to market losses over the past 6 months and have lost almost all risk appetite to participate incrementally in the bond market.
Investor Implications
The list of regulatory interventions in support of the bond market has grown considerably, and in a short span of time. Thus the government chose to borrow less, especially so in the first half of the year, and also reduced its bond supply in the so-called belly of the curve. There is also chatter of a sovereign issue at some point to further alleviate the excess supply in the local market (although this ‘rumor’ seems to have died for now). Then the RBI, despite taking a harsher stand before, allowed banks to spread mark-to-market losses. It then tweaked FPI participation criterion (more on this required though) and finally announced the first OMO bond buyback for the year, much ahead of market expectations. The strong takeaway from these definitely is that it is now well understood by the issuer as well as the regulator that there is a problem in the bond market and that it needs addressing. To us it is not as much about the level of bond yields anymore than the fact that the market for financing is largely frozen. The very sharp rise in short end yields has basically ensured that corporate borrowing, save in money markets, has almost come to a standstill.
The problem has to be looked at symmetrically: If memory serves correctly, members of the RBI have previously pushed against a hypothesis that monetary policy in India cannot target CPI. This presumably means that the channel of financing is alive and well in India and can curtail inflation through curtailing aggregate demand. If this is to be accepted then it must also be true that the recent very large spike in bond yields and the virtual freezing of the financing market should impact aggregate demand and hence growth down the line. For a recovery that was being termed nascent till not very long back, this is an unnecessarily headwind. This is especially so since on paper the MPC is only now even contemplating switching stance to restrictive or ‘withdrawal of accommodation’.
From an investor standpoint, these recent regulatory interventions should definitely be construed as a constructive sign. However, this shouldn’t automatically be a trigger to buy long duration. There are enough local and global headwinds including higher oil prices and a recent upturn in local inflation momentum. Despite these headwinds, there has been a significant bear flattening of the yield curve over the past month or so. To us, there is nothing fundamental here and the flattening is on account of local market specific factors including:
1. Lower supply in the belly of the government bond curve under the revised central government borrowing calendar.
2. Duration switching by particular FPIs that sold short end and bought belly securities over a short span of time.
3. PSU banks having removed short end securities from HTM to sell in open market.
4. Bank traders having hit stop losses at short end, especially as hedging via swap started becoming inefficient.
5. Asset liability management (ALM) desks of some banks also apparently having forced into stop losses.
As a result of these, there has been excess supply at the short end of the bond curve (up to 5 years) over a very short span of time versus the belly and long end. We don’t expect this trend to last for too long, especially now that RBI itself has moved in to remove some of the pain of excess supply in the market. From a macro perspective, there is no reason for such a flat curve. While it may be argued that flat curves are logical with market forward pricing future rate hikes at the short end(like in US for instance), this also depends upon the starting point for rates and the quantum of hikes expected. Thus at current levels the front end of the curve is already discounting around 75 – 100 bps of rate hikes over a period of time (and probably 50 bps immediately). Also, given the lack of duration appetite it is likely that banks will also prefer the short end whenever they want to start adding to their SLR. Finally, the long end is currently getting anchored by large insurers / pension. Their demand is likely to weaken as we go deeper into the year.
For all these reasons, we think the current bear flattening of the curve should be faded. Instead, as levels start stabilizing, front end rates (up to 5 years) offer much better risk-reward. Purer carry strategies like AAA oriented ultra short / short / medium term funds also make sense given the very attractive carry over liquid funds and the fact that RBI seems to be finally moving to address the current logjam in the financing market.
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