The Monetary Transition
Inflation has been one
of the biggest talking points globally in 2021. Rapidly rising commodity prices
and acute supply chain disruption caused by the pandemic pushed up inflation to
levels not seen for a very long time.
In the US, consumer
price inflation jumped to 6.2% in October 2021, the highest print in over 30
years. In the Euro zone, CPI inflation surged to 13 years high at 4.1% in
October 2021. Other Advanced and Emerging economies too witnessed an abnormal
surge in inflation in the past few months.
Chart – I: Broad-based rise in Inflation
The chart is prepared by IMF and was published in the IMF World Economic Outlook in Oct 2021
As per the IMF, “headline inflation is projected to peak in the final months of 2021, with inflation expected back to pre-pandemic levels by mid-2022 for both advanced economies and emerging markets country groups, and with risks tilted to the upside.”
This is a near-consensus view that inflation will cool off from current levels in the coming 2-3 quarters as economies open up and the supply chain gets back on track. However, some expect it to remain above the so called ‘Neutral Rate of Inflation’ (rate of inflation at which demand and supply in an economy are in balance) for a longer period and require an immediate intervention by the policy makers to control its spiral.
Policy Shift
On the policy front, a distinct shift towards unwinding of pandemic stimulus is already taking hold. Many of the central banks have embarked on the path of reducing the crisis times liquidity and even hiking the interest rates.
Chart – II: Policy Shift in Central Bank
Source – RBI Bulletin, Data as of November 9, 2021
The US Fed, in its November meeting, announced
the tapering of its asset purchases at the pace of USD 15 billion per month.
Currently, the Fed is buying USD 80 billion of Treasury securities and USD 40
billion of agency mortgage-backed securities (MBS) on a monthly basis. At the
announced pace of tapering, the FED will stop its bond-buying completely by
mid-2022.
This was well communicated by the FED in
advance and was awaited by the markets for some time. What caused the chaos in
the market is that it started to move away from the Fed’s ‘transitory’
narrative on inflation.
The risk is that prolonged supply disruptions and elevated commodity prices coupled with demand pickup and unprecedented fiscal spending could de-anchor inflation expectations and force the Fed to tighten the monetary policy at a much faster pace than currently priced. This leaves the near-term outlook for central bank policy highly uncertain.
The bond market sell-off in the last two months is a manifestation of this conflict between the market and the central bankers and the increased policy uncertainty.
Chart - III: Bond Selloff on Inflation/Policy Uncertainty
Source – Refinitiv, Quantum Research; Data as of November 17, 2021
Domestic
Policy Path
India
has its own story on inflation. Consumer price inflation in India inched up marginally
to 4.48% in October 2021. This was the second consecutive month when retail
inflation was in a 4% handle, closer to the RBI’s inflation target or the
perceived ‘Neutral Rate of Inflation’ in the Indian context.
This brought in a
sense of ease among the Indian policymakers, especially at the time when most
of the major central banks are boxed by the abnormally high inflation trend.
Although headline CPI
numbers are in a comfortable zone, the worrying part is that much of it is due
to a favourable base effect from the last year’s high vegetable prices. As the
base effect fade away by early 2022, inflation will likely move up again to the
6% mark.
The underlying
inflation trend as measured by the Core-CPI (excludes the volatile food and
fuel prices) is also running close to the RBI’s upper threshold of 6%. Inflationary
pressures are reasonably broad-based as over half of the CPI basket is
witnessing an inflation rate above 6% in the last three months. While over 20%
of items are growing at more than 8%.
Chart – IV: India Retail Inflation near the RBI’s Upper Threshold
Source – MOSPI, Quantum
Research; Data as of October 2021
The RBI Governor
Shaktikanta Das, in a recent interview, has shown concern over elevated core
inflation and highlighted it as “a policy challenge”.
With no increase in
policy rates or in removing the durable liquidity, the RBI is behind many of
its emerging market peers on the monetary policy cycle.
Over the last three
months, it did act on the liquidity management and loosened its control over
the sovereign yield curve.
The RBI stopped its bond-buying
program – GSAP and normalized the liquidity operations by increasing the
quantum of variable rate reverse repo auctions (VRRR). This pushed the bond
yields higher across the maturity curve with maximum 1-3 years maturity segment
which moved up by about 30 basis points in the last two months.
Chart – V: Increased liquidity absorption through VRRRs pushed short term rates higher
Source – RBI, Refinitiv, Quantum Research; Data as of October 2021. Past Performance may or may not be sustained in future.
The next logical step
in direction of policy normalization is a hike in the reverse repo rate. This
should be followed by a change in policy stance from ‘accommodative’ to
‘neutral’ and subsequent repo rate hikes.
The direction of the
monetary policy is more or less built in the market expectation and the current
yield curve. Incremental change in the market expectations will be driven by
the timing of stance change, the pace of rate hikes and the length of the rate
hiking cycle or the terminal repo rate.
In the August 2021
edition of the Debt Market Observer – Investing in
The New Normal, we argued that the rate hiking cycle would be much shallower
this time with the RBI trying to keep the terminal repo rate closer to
5.0%-5.5%.
This assessment was
based on the fact that much of domestic inflation is coming from supply chain
disruptions and one-off price adjustments which should fade away over the period.
The pace of rate hikes
will also be influenced by –
·
Pace of growth recovery
·
Household inflation expectations
·
Global monetary policy
· Commodity prices with particular focus on crude oil
Taper without Tantrum
The US Federal Reserve has started to phase out its bond-buying program – a process commonly referred to as ‘Taper’. This was very well communicated and markets were better prepared this time. However, as the liquidity stops simultaneously across many major economies, we may see some bouts of volatility in the bond and currency markets.
India
was one of the worst hit economies during the “taper tantrum” episode of 2013.
India’s macroeconomic position and external accounts are in much better shape
now than what it was in 2013. The RBI has also built a significantly large war
chest of foreign exchange reserves, which now stands above USD 640 billion.
Though
we may not see a meltdown like 2013, Indian markets might not be immune to any
large shock in the global sphere given that India has attracted record amount
of foreign capital flows in the last one and half years and the Indian Rupee is
relatively overvalued compared to its emerging market peers.
Table - I: India not ‘Fragile’
anymore?
|
India Macro Conditions |
Pre and during Taper Tantrum of 2013 |
Current Inflation Tantrum 2021 |
|
GDP Growth |
Post GFC stimulus
pump primed growth but fizzed off |
Below potential
going into COVID. Recovering better than expected |
|
Inflation |
High Producer and Consumer Inflation |
Near RBI’s upper threshold |
|
Oil Prices |
Hovering around
$100/brl |
Near $80/brl,
expected to rise |
|
Current Account
Deficit |
Very high; >3% of GDP |
Under Control; Near 1% of GDP |
|
FX Reserves and External Debt |
Low reserves. High corporate FX
debt due for maturity |
FX reserves well
above Total External Debt. Low Corporate FX leverage |
|
Foreign Portfolio
Flows |
Bond Tourists Weak FDI |
Long term real money flows / Strong FDI |
|
Real Interest Rates |
Deeply negative |
Negative |
|
Currency Valuation |
Over-valued |
Over-valued |
Source: Quantum Research
Outlook – Volatility
Ahead
Bond markets have a
lot to watch for in the coming few months. Monetary policy is in a transition
mode in India and across the developed world. If history is any guide, these
transitions from easing to tightening monetary policy tend to become chaotic
with a lot of sentimental market movements on both sides. Thus, we should be
prepared for increased level volatility in the bond market.
Although the macro backdrop is
unfavourable, valuations at both the short and long end of the curve are at
comfortable levels. We particularly like the 3-5 years segment of the
government bonds which in our opinion is already pricing much of the liquidity
normalisation and a start of rate hiking cycle by end of this year. Given the
steep bond yield curve, 3-5 years bonds also offer the best roll down potential
and thus a reasonable margin
of safety in the rising rate environment.
The front end (up to 2 years
maturity) yields should face the maximum impact of the rate hikes and yields
should move higher in this segment.
At the longer maturity segment,
current yield levels look good from a perspective that the terminal repo rate
in this cycle may remain much below its pre-pandemic normal level. However,
rising crude oil prices and absence of assured RBI buying coupled with high
duration impact have raised the risk level in this segment. In the near term, crude
oil price is a key variable to watch for this segment.
Chart – VI: India Sovereign Yield Curve is steepest in a decade
Source – Refinitiv, Quantum Research; Data as of November 17, 2021. Past Performance may or may not be sustained in future.
We will also be watchful of the
developments on the global bond index inclusion of Indian bonds. With much of
preparatory work having already been done, an announcement on the index
inclusion could come as soon as early next year.
As per estimates this would attract USD 30-40 billion of inflows in the first year itself and will open up a consistent demand source for the Indian government bonds. (Read Will Foreigners Bond with India)
Portfolio Allocation - Balanced and Dynamic
Given the above-market view and need for balanced risk exposure, Quantum Dynamic Bond Fund (QDBF) is currently positioned at the 2–5-year part of the yield curve. Given our view of increase in volatility, we will remain vigilant to make tactical adjustments to the portfolio whenever required.
We continue to seek opportunities in the longer
end bonds for a tactical trading position. Given the expectation that the
terminal Repo Rate in this cycle will be much lower than the pre-pandemic
normal (refer Investing in the New Normal), valuations do look attractive
even at current levels. However, in the current environment with rising crude
oil prices and lesser RBI support these bonds carry very high risk. We would
wait for some of these risks to subside before taking a position in the longer
end bonds.
We understand that the economy and markets are currently adjusting to an unprecedented shock. There are too many moving parts and things are still evolving. Thus, any forecast about the future is susceptible to change based on policy responses from the government and the RBI and changes in global markets.
We stand vigilant to review our outlook as and when new information comes. We retain our right to remain dynamic in our portfolio construction to respond to the evolving economic and market conditions.
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