Policy responses to the Coronavirus have commenced full steam with the Fed rate cut yesterday. With this a global policy acknowledgement of material risks is now firmly in place. We assess below the current and potential responses in light of preferences ‘revealed’ already by major policy agents around the world prior to the virus outbreak.
The US Fed
The US Fed Chairman has consistently made two points over the past few of his post policy press conferences. One, the Fed outreach events are telling them that the recovery is lately percolating to economically weaker sections. Hence Fed considers it very important to sustain the recovery. Two, there’s an embedded fear that if inflation expectations don’t pick up, the US may undergo a ‘Japanification’ or more lately ‘Europification’, where persistent inflation and expectations undershoot start creating perceptions of ineffective monetary policy. The Fed’s review of its tools, likely to be unveiled by mid-year, will also likely take into account measures to possibly compensate for previous undershoots in inflation.
The Fed has hence had a clearly revealed preference for keeping the recovery going and minding the gap on inflation and expectations . Also, it has been mindful that when rates are closer to the zero bound and the space to incrementally act is lesser, it is best to be pre-emptive as far as possible. These preferences have clearly been revealed in the 50 bps out of meeting cut yesterday. Also, monetary policy works via financial conditions and confidence channel which would remain relevant even if the general assessment is that direct help from monetary policy in a situation like this will be limited. The Fed chair acknowledged as much in the post cut press conference, highlighting the role for health experts as well as of fiscal policy. However the decision to act is probably the correct one nevertheless, given the above mentioned current leaning of policy direction as well as the fact that evolving data on the virus situation is very dynamic and there was a need to show that the Fed was on top of the problem (though markets had once again started to “lead” the Fed). This also means that future such action may well be forthcoming, given the leaning that it is probably safer to do more than less. Markets continue to lead the Fed lower in terms of forward expected pricing.
Other Major Global Policy
It is reasonably obvious that more widespread global easing should be forthcoming. This was indicated somewhat by the Fed Chair in the press conference but also for the reason that no other major economy can afford a tightening in their relative financial conditions with respect to the US. So now that US has moved, other banks may anyway have to move as well. However, the quantum and form will depend upon space and format respectively, and individual revealed preferences. For instance, the European Central Bank (ECB) is struggling with the backlash from negative policy rates where feedback from economic agents seems to suggest that the negative rates may now be doing more harm than good. Also, the new President Lagarde is more of a consensus builder and will probably take into account viewpoints from the more traditional board members as well. This means that incremental measures may lean more towards targeted incentives even as more forceful arguments are made for fiscal responses.
The RBI
In India, Governor Das may once again have been prescient, already moving forward with reasonably aggressive non- conventional tools which had more than compensated for the absence of a rate cut at the last policy. However, what is also true is that current events may allow the MPC to find room sooner than expected for incremental rate cuts. Again the revealed preference in MPC (on aggregate, not necessarily for each individual member) seemed to be to look for room to ease as soon as inflation allowed, even before the impact from the Coronavirus had taken hold. With new evolving information, the nudge is likely to come sooner than before. The RBI, on its part, has a dominant revealed current preference for bringing back credit growth. It is also noteworthy that the central bank chose to put out an assurance statement with respect to evolving developments, despite already being in the midst of substantial incremental non- traditional monetary easing. All of this means that monetary policy, conventional and otherwise, will continue to play a pivotal role for now with consequent benefits for quality interest rates.
India’s Fiscal Policy
The finance minister’s revealed preference is also similar to that of the RBI; to get credit growth to rebound. This is also basis a recognition that scope for incremental fiscal response has been somewhat limited given the well documented constraints. In fact this space may get even further constrained if lack of growth buoyancy stresses tax growth and tepid financial markets stress capital receipts targets. However, it is unlikely that the government will compromise on spending to meet the fiscal deficit targets. The revealed preference here as well has been to show willingness to re-interpret fiscal frameworks in light of evolving growth trade-offs and the current year may yet provide enough grounds for further examination of the already revised targets.
Strategy and Implications
The Coronavirus comes in the midst of a global expansion that was already late stage. Thus while owing to inventory re-stocking and the beneficial effects of last year’s Fed policy pivot some initial rebound was expected in the initial part of the year, the two large economies of the world (US and China) were still expected to continue to slow. Now the virus has cut short the expected first half rebound. Indeed, some new assessments are already projecting substantial cuts to global growth this year. Also while manufacturing rebound at a later stage may compensate for ground lost now, it is difficult for services to behave the same way.
All this implies that global monetary policy will continue to be extremely supportive. In India too, the RBI’s revealed preference will get a further leg up and conventional easing may start supporting unconventional tools already in deployment. Indeed the swap market is already pricing the next 40 – 50 bps of repo rate cuts. This means a continued constructive environment for quality interest rates and a continued widening of the gap between the “haves” and the “have-nots”. Finally, it is likely that fiscal policy finds itself getting more restive despite the obvious constraints on the revenue side.
The above means that there is a greater likelihood of more steepening pressure on the yield curve. However, this statement needs some qualifications: the very front end of the government bond curve (up to 3 – 4 years) has clearly outperformed massively since the announcement of the long term repo operations from the RBI. There may be limited relative gains to be made here incrementally for real money, given the lower duration as well. However, the spread between 4 year to 7 – 8 year government bonds has, at the time of writing, widened to almost 80 bps. Subsequent spreads (longer bonds spread over 7 – 8 year bonds) are still relatively low. In our view, this makes the 7 – 8 year government bonds the “sweet-spot”, with a strong likelihood that the very wide spreads on offer versus shorter end bonds will likely compress over the coming months. The longer end may struggle once the current momentum fades, also in part due to the significantly higher state loan supply expected over the year ahead. The same anticipated state loan supply makes the 10 year point on the AAA corporate curve less attractive.
Disclaimer:
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the security may or may not continue to form part of the scheme’s portfolio in future. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. The decision of the Investment Manager may not always be profitable; as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. Neither IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.