The recent RBI policy, and more particularly the post policy interactions, distinctly bore the mark of the new Governor. Assessments made were bolder and unequivocally benign. There was much more sympathy for the government including for the recent interim budget which, it may be remembered, wasn’t as well accepted by the market. Indeed, the Governor went so far as to defend the GST assumptions in the budget and even highlighted that the slippage from targets is modest. The reaction function of RBI / MPC was laid out with much more decisiveness as the headline CPI as well. Also, the forecast for CPI seems more decisively sanguine with Governor Das indicating that the projections have taken into account the possible inflationary impact of the budget’s farm income scheme. In summary then the Governor seemed completely relaxed on CPI, including on the effect on it from the budget, and seemed firmly focused now on helping growth. In this context, the RBI assessed that some output gap may have again opened up versus its assessment in December that the output gap remains virtually closed.
While this commentary had already started expectations of another cut in April, the majority first reaction to the RBI’s inflation assessment was that it risked being a shade too sanguine. However, the recently released CPI data has aligned market much more firmly with the assessment made by the central bank. Thus the CPI for January at 2.05% has undershot market expectations by a full 50 bps or more. This will likely lead to RBI’s latest downwardly revised Q4 CPI estimate of 2.8% getting undershot again. Not just that, the Q3 FY 20 forecast of 3.9% now seems much more comfortable than before. The internals of the latest CPI print were quite subdued as well, as shown in the various cuts presented below (source for all charts is CEIC).
Notable here is the deceleration in core CPI as the recent (mysterious) spikes in health and education have subsided. Although the level of core is still uncomfortably high, the directional view will matter more and so long as the momentum on this continues to be subdued it may not be a worry either for RBI or for markets. Also notable here is the chart on CPI ex of vegetables, fruits and pulses. Even excluding these 3 items that are in deflation currently, CPI is at its lowest ever in this CPI series.
Takeaways
As things stand, the new decisive RBI seems more in tune with both the global backdrop as well as local developments on CPI. The global slowdown in data continues and on the margin is inviting shifts from other central banks as well including, and most notably, from the US Fed. This then remains a very positive environment for bonds. With the last CPI undershoot locally, April rate cut is largely cemented in market’s expectation and one cannot rule out one more cut after that as well. This is especially if RBI gets more concrete signs that growth is slowing and output gap is widening more.
For bonds, historically the two large anchors have been inflation and fiscal. Each is however a necessary condition but not a sufficient one as the current phase in bonds is so painfully demonstrating. Thus if a few years back a discussion had ensued that India will probably post 3 successive years of sub 4% CPI, most may have opined that the 10 year government bond will likely be around 6.5% or lower. CPI has probably delivered and yet bonds are stuck in a frustratingly elevated range for now, and even after significant supply absorption by RBI via open market operations (OMOs) . Even more, state development loans (SDLs) and quasi sovereign AAA corporate bonds are a full 100 bps over the 10 year government bond and some 500 bps over average CPI! This is a simple instance of substantial crowding out and macro policy makers have to pay attention to this irrespective of optical consolidation endeavors for the public deficit. If a quasi-government institution is forced to borrow at 500 bps real yield (assuming that the current CPI is representative of the economy), then the bond market has to be considered shut for all practical purposes for long term borrowing by private companies.
From a bond strategy standpoint, and notwithstanding the above headwind, real money funds with active or long mandate may no longer be able to completely ignore the duration part of the curve. This is because the spread between say 4 year and 10 year has widened to almost 40 – 50 bps across SDLs and corporate bonds thereby making the latter somewhat more attractive. Also, from a ‘one and done’ for now kind of hypothesis with respect to rate cuts, most participants are now being forced to consider the possibility of even two more cuts in the current year. Also, given currency in circulation (CIC) trends, it is possible that OMOs continue into April as well. Our preference for duration is largely via the best quality AAA corporate bonds and SDL where spreads are at 100 bps or thereabouts over government bonds. While supply is a near term headwind to these bonds, this pressure is expected to considerably abate into the first part of the new financial year. Thus these constitute an attractive buy and hold trade if one is playing some sort of a structural trade on interest rates. For more conservative investors looking for better risk versus reward optimization, though, the 2- 5 year AAA corporate bond segment continues to look the best placed.
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