Introduction
A lot has changed over the past few months. From a point in September where market was pricing in more than three back to back further rate hikes, the 1 year swap currently at 6.95% is now pricing in about one rate hike; and that too not immediately. To take another example, the 4 year government bond (our favorite trade for a long time) has rallied by more than 70 bps from its recent peak. A lot of factors have helped in this dramatic move down in yields. First the RBI committed more aggressively to Open Market Operations (OMO) bond purchases since late September as core system liquidity deficit started to rise more appreciably. Two, in its October policy it effectively broke the market’s false causation that interest rate hikes are needed as a defense against the rupee weakness. Three, food inflation has simply refused to pick up thereby setting the stage for meaningful undershoots to even the most recent downwardly revised forecasts of the RBI. Four, oil prices have seen a dramatic drop, with Brent prices falling some 30% from its early October peak. This has also had a sanguine effect on the rupee.
A View Recap
Our ‘big picture’ view expressed in late August (please refer “Making Movies: “The Big Picture”, dated 21stAugust for details https://www.idfcmf.com/insights/making-movies-the-big-picture/) had two major components: One, that this rate cycle is likely to be shallow. Two, OMO purchases will be well in excess of INR 1,00,000 crores between October – March. The view of a shallow rate hike cycle was underpinned by an expectation that peak growth is past us and that the recent momentum in India’s growth should be looked at as payback to some extent for the earlier slowdown which was largely owing to domestic reasons. The view was that the period of synchronized global recovery is now past and will tell on local prospects as well through the trade and financing channels. The sequence of value we had preferred ran from government bonds, to AAA, to lower rated. We had cautioned that the macro backdrop is ripe for spread widening amidst rising refinancing risks.
Over the turbulent month of September, we had argued against an interest rate defense for the currency. Our view was that financial conditions had already tightened significantly and that a rate hike via the Monetary Policy Committee (MPC) cannot be for currency considerations, but only if the weaker currency now leads to an assessment of higher (Consumer Price Index) CPI in the future (please refer “Back To Bedlam? A Bond & Macro Update, dated 6th September for details https://www.idfcmf.com/insights/back-to-bedlam-a-bond-macro-update/). In fact as financial conditions continued tightening, helped by certain credit episodes, we thought that the RBI should move towards ensuring better policy predictability as a means to establishing some measure of financial stability. We had expressed a view that one should expect less and not more hawkish outcomes of policy relative to expectations (please refer “Too Tight? A Market Update, dated 24thSeptember for details https://www.idfcmf.com/insights/too-tight-a-market-update/ ).
The Shifting Narrative
Courtesy the list of factors mentioned in the introduction above, the narrative has somewhat shifted for fixed income. Thus as is evident in the view recap above, the argument then largely was that the market was overly pessimistic with respect to its forward rate hike expectations. Hence, it made sense to be aggressively long the front end of the curve. The trade would also be helped by the under-pricing of OMOs at that juncture.
However, one can now possibly lead with a more positive narrative. As noted before, the 1 year swap has retraced meaningfully and is currently pricing in just one rate hike. The graph above tracks the swap rate versus movement in the rupee. As can be seen, while both have moved in the same direction as is intuitively to be expected, the fall in swap predates the strengthening in the rupee tracking the RBI’s move to aggressively reestablish policy rates as a tool to manage inflation and not defend the currency. Alongside, the recent fall in oil prices is also tracking a demand narrative; just as was the case with the fall in other commodities earlier in the year. Growth around the world barring the US has been slowing for most of the year.
The graphs above track the Citi Economic Surprise Index for major economies. As can be seen, data surprises have largely been negative for the past few months for major economic blocks including Euro Zone, Japan, China, and Emerging Markets. This kind of an external environment poses a strong headwind to growth for our own economy as well. This underscores our key view of peak growth being past us. The interesting economy to watch for obviously is the US. The hypothesis to test is this : A phase of synchronized recovery that lasted till 2017 turned into unsynchronized growth over 2018 as the US continued to grow responding to a late cycle fiscal stimulus whereas the rest of the world started to slow. Can the next phase now be of a synchronized slowdown as incremental US growth impulses start catching up with the rest of the world? For now one has to keep this as a live hypothesis and await further confirmation. Interestingly, key Fed commentary lately has taken note of the international growth slowdown, the prospects of fading fiscal stimulus and the lagged effect of tightening already done.
Where Do We Go From Here?
It is very likely that the current rate hike cycle is already over. Near term CPI prints will be sanguine with the average CPI for October – March currently tracking closer to 3.5 – 3.75% versus RBI’s most recent, downwardly revised forecast of 3.9 – 4.5%. There is a risk, however, for CPI to rise meaningfully from there especially given that the current composition seems quite untenable with food inflation running negative. Indeed, this is probably why many rate hike forecasts have been retained but pushed forward. Hence, it is also important to assess where we are in the global economic cycle. Our leaning, and basis indications so far, is towards a hypothesis that we are very late cycle with fading incremental growth impulses. Specific domestic triggers are adverse as well, including the possible impact on credit flow to certain sectors post the recent credit concerns. Thus if our hypothesis is correct, the current phase of lower CPI backed by low food prices will give way to a phase of slower growth which will take away the MPC’s current concerns with respect to a closed output gap. Hence, we expect that rate hikes have not been pushed forward but been eliminated altogether.
While RBI has stepped up liquidity provisioning, it is now a case of running to stand still. Thus even after INR 1,26,000 crores of OMO purchases done so far, our assessment is that core liquidity will still be deficit around INR 1,75,000 crores or more by year end. Thus there is still some heavy lifting to do on liquidity and we think the RBI will have to do another INR 75,000 crores at least of OMOs by year end.Some offset may be provided if dollar flows turn and RBI can intervene to build some reserves. This will be especially true if the US dollar were to indeed stabilize or turn direction and emerging market flows were to restart to some extent. From a bond perspective, however, this will create bond demand and to that extent market may not mind the somewhat lower OMOs. Finally, there is chatter of a CRR cut as well. We believe that the bar for this is quite high especially since the stance of monetary policy has recently been changed to ‘calibrated tightening’.
From a strategy standpoint, overweight quality front end (up to 5 year sovereign and AAA bonds) remains a very compulsive trade. As can be seen in the graph below, while yields have rallied somewhat, spread to overnight rate on 5 year AAA bonds is still close to recent historic highs. It is quite likely that this compresses going forward as market unwinds any residual rate hike expectations.
The large barrier for longer maturities has been fiscal uncertainties. Indeed, as things stand, fiscal looks like the weakest leg of our macro currently. Balancing this, however, is the ongoing verbal commitment from senior government officials of no breach to targets. Also, in the one month since we last reassessed the long end, CPI impulses have faded further including with a massive correction in crude prices. Even though some bit of this correction may well prove to be excessive, it is quite likely that the range is now more stable and significantly lower than the highs touched in October. All told then, some selective exposure to the 10 year segment including via spread assets like corporate bonds and state loans may be in order in active managed bond and gilt funds.
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