We have discussed in detail before the global and local factors that have led us to take a very conservative stance in our actively run bond and gilt funds. The ‘epicenter’ so to speak has been the US where we had flagged discomfort with the extent of disequilibrium between inflation dynamics and the Fed (https://idfcmf.com/article/6269 ). We had reiterated our concerns, and the sources of potential volatility (https://idfcmf.com/article/6329 ); and basis these had moved to a significantly large cash / near cash positions in the active mandates. Since then, the Fed has indeed done a ‘hawkish pivot’, de-facto switching target variable from unemployment to inflation. Subsequently, the Bank of England (BoE) became the first major central bank to actually hike rates despite the UK being in the midst of a severe Omicron wave.
So far so good. However a point of worry (from our view standpoint) has been that bond yields in these markets have refused to budge, making them the proverbial dog that didn’t bark. Part of the reason as noted before could be year end illiquidity and market positioning. And yet, the phenomenon is significant. At the time of writing US 10 year was around 1.4% while UK 10 year was barely 0.75% (almost 50 bps from their highs in late October). Granted the vicious Covid wave there but the central bank didn’t let that come its way of hiking rates. Further, the Fed also seems to be now treating new virus iterations as a 2 way risk, impacting inflation as much if not more than growth, and thus seems less willing to delay normalization on this account. And yet the US curve continues to be quite flat with the market still comfortable with the idea that even as the Fed will start lifting rates in 2022, it won’t get much farther beyond 1.5% in this cycle. This is even more curious as consumers are still sitting on very large savings from the substantial government transfers made to them since the pandemic started. A very recent news (implications still unfolding) pertains to now considerable difficulties in the path of Biden’s next USD 1.75 trillion fiscal package in the form of a key Senate Democrat rejecting the proposal, thereby making the passage virtually impossible in the 50-50 divided Senate.
We had also focused in our previous investment notes on the fact that though our yield curve remains steep, it hasn’t substantially cheapened over the past few months while the incremental macro-economic news has been adverse. However, the same is true thus far for the economies in the most disequilibrium with respect to inflation (US and UK being two stark examples as highlighted above). Thus from a relative valuation standpoint, our concern so far doesn’t seem to hold much water (relative valuations basis real yields, even assuming a 5%ish longer term CPI for India, look even better). However, there’s one point that remains a valid concern from our initial list: India’s own macros on the margin have somewhat moved adversely (nothing alarming yet but the information ‘flow’ is negative). Thus incremental pressures are evident on all 3 parameters of bond market interest: fiscal, trade account, and core inflation. A small balance to this is the recent undershoot to our expectation on headline CPI for November. While this is comforting as it stands, we remain worried about the underlying evolving dynamics (https://idfcmf.com/article/6469 ). A final point of note is that the recent RBI policy was fairly more dovish in its assessment than we would have thought even though the move towards normalization very much progresses with enhancement in the VRRR program (https://idfcmf.com/article/6431 ).
Portfolio Update
While the environment can by no stretch of the imagination be deemed to be sanguine, the amount of carry loss embedded in steep yield curves requires things to move relatively quickly if one is to benefit from holding large amounts of cash. Now that the Fed pivot (not to mention BoE) has been digested by bond yields, at least for the time being with nary a burp, we aren’t so sure that we will get a substantial reset in a short period of time. Adding to the uncertainty is a raging Omicron wave which will likely make data that much difficult to read for longer (although central banks will almost certainly have a very high threshold for dovish action this time around). The last couple of days have provided some rise in yields which, given the balance of risks as described above, we have found difficult to ignore. Accordingly, we have re-deployed the majority of cash / near cash that we have been holding in our active duration bond and gilt funds, into sovereign bonds maturing between 2026 – 31. While the focus is towards the 4 – 5 year segment as before, we have chosen to somewhat diversify the bucketing taking account of the heightened uncertainty as described above. Again, as always, what has been presented here represents our current thinking and can change at any point in time.
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