The Great Divergence
The Indian Bond Markets have been mollycoddled over the last three
years by the incredible actions of the Central Bank.
The Reserve Bank of India (RBI) cut interest rates, eased
liquidity, and bought record amounts of government bonds to anchor market
interest rates at low levels.
The bond market embraced this arrangement and never second-guessed
the RBI’s guidance despite rising inflation and a higher bond supply due to a blown-out
government balance sheet.
This was a cozy symbiotic relationship (refer The
DAS PUT); not only in India, but
around the world. That though is about to change.
As growth recovers and inflation rages, the Central bank,
not only in India but from around the world will not only raise interest rates
but will also reduce its liquidity support to the bond markets.
The possible divergence in the timing, the extent and the
pace of the actions will be the key driver for the bond markets in 2022.
Misunderstandings are likely to creep into this symbiotic
relationship. Trust will be at a premium. Divergent viewpoints will lead to
volatility.
We expect considerable volatility in the Indian bond market
in the coming 6-9 months due to:
a) Divergence in the actions of
the RBI and its expectations in the bond market
b) Divergence in the actions of
the US FED and its expectations in global asset markets
c) Divergence in the EXIT policies of central bankers around the world impacting asset prices and flows to India
Divergence on Inflation assessment
“I think
it's probably a good time to retire that (transitory) word and try to explain
more clearly what we mean.” – US Federal Reserve Chairman Jerome Powell,
statement at a Congressional hearing.
In India, the consumer price inflation (CPI) averaged 5.96% in the
last 24 months (December 2019-November 2021) as against an average of 4.1% in
the preceding 5 years (December 2014-November 2019).
Although the last three readings of headline CPI inflation were lower
between 4%-5% (4.35%, 4.48% and 4.91% in September, October and November 2021,
respectively), it was largely due to base effect from high CPI reading during the
same months of last year (7.27%, 7.61% and 6.93% respectively in Sep, Oct and
Nov 2020).
Much of this distortion in inflation numbers was caused by a sharp
rise and fall in vegetable prices. The ex-vegetable inflation, which
constitutes about 94% of the CPI basket, stood between 6.64%-6.87% during the
last three months; and for the last 12 months, it averaged at 6.4%. This is not
just significantly higher than the RBI’s inflation target of 4%, it is also
holding above the RBI inflation tolerance band of 2%-6%.
Evidently, inflation has been a lot more persistent over the last
two years and there is no clear sign of it coming down in 2022. We see headline
CPI inflation moving higher (possibly above 6%) in the coming months as the
base effect fades away.
Furthermore, telecom and electricity tariff hikes, the proposed
increase in GST rate on apparels and general increase in prices of goods across
various categories will continue to put upward pressure on the inflation
trajectory. We are also seeing services inflation picking up gradually and as services
demand gains momentum, it could drive inflation even higher.
Despite the elevated inflation trend, the RBI was surprisingly
dovish in its monetary policy statement on December 8, 2021. It downplayed the
inflation risk and continued to prioritize growth over inflation. The governor
said – “we remain committed to our stance in support
of our overarching priority at this juncture to broaden the growth impulses
while preserving monetary and financial stability.” There
was no indication of change in stance or potential rate increases anytime soon.
Chart – I: Inflation Holding above the Repo Rate
Source:
MOSPI, RBI, Quantum Research, Data upto November 2021
However, just as the US FED made a U-turn on inflation being
transitory, we expect a similar change in tune from the RBI.
Global Inflation War
In the December meeting, the US Federal Reserve (FED) made
a significant hawkish turn as they dropped the long-held narrative of inflation
being transitory and characterized ‘high inflation as the biggest threat
to full employment goal’.
They accelerated the pace of QE
tapering (reduction of bond buying by the FED) from USD 15 billion/month to USD
30 billion/ month to end its QE program (bond purchase) by mid-March 2022. The
faster withdrawal of the bond buying program is an indication that the FED will
start the hiking rate very soon.
The ‘dot-plot’, which reflects the future interest rate expectations of the FOMC (interest rate setting committee of the US Federal Reserve) members now expect 3 rate hikes in 2022 and 2023 respectively.
Chart – II: FED’s Dot Plot indicating ‘faster rate hike’
Source
– Bloomberg, December 2021
This is a clear change in stance
by the FED. It also indicates that the economy is no longer in a crisis and
that monetary policy need to move away from crisis time actions.
Divergent EXIT policies of
global central banks
The FED was not alone. The Bank
of England (BOE) also intensified its fight against inflation as it became the
first G7 central bank to hike interest rates since the onset of the pandemic.
The European Central Bank (ECB) also called for vigilance on inflation;
however, it adopted a more gradual approach of policy normalization.
Chart – III: Changing Policy Landscape – More Rate hikes coming in 2022
Source – Bloomberg, December 2021
India in the World of Uncertainty
Changing global policy landscape
has implications for emerging markets like India. Monetary tightening (liquidity
withdrawals and rate hikes) in the developed world typically causes capital
outflows from emerging markets (EM) and puts pressure on EM currencies and
bonds.
EM countries with low/negative
real interest rates (interest rates minus inflation rate), high debt levels and
wide fiscal and current account balances are more vulnerable.
Chart – IV: Emerging market currencies lost value against US dollar in 2021
Source – Bloomberg, Data upto December 20, 2021
From a global perspective, India
is lagging behind many of its emerging market peers in normalizing the monetary
policy and hiking interest rates. Although we believe that India is not fragile
anymore like it was in 2013, it will not be immune to external shocks
caused by faster FED tightening. Thus, the RBI will be forced to change its
stance and begin hiking interest rates sooner than they prefer.
Table - II: 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 |
Under control within RBI target |
|
Oil Prices |
Hovering around
$100/brl |
Around $74/brl |
|
Current Account Deficit |
Very high; >3% of GDP |
Current Deficit <2% |
|
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 |
Globally, the biggest risk for
the markets will stem from the US FED beginning to reduce the size of its
balance sheet. This means that the US FED will be taking liquidity away from
the markets.
The fact that this was discussed
in the December FOMC meeting suggests that, if conditions persist, the FED may
not only hike rates but also begin the process of allowing bonds that it holds
to mature and/or selling bonds to reduce the size of its balance sheet.
This scenario is not priced in
the markets and will be a big scare for risk assets especially in emerging
markets that have benefited from global liquidity.
On the positive side, India is expected to be included in the global bond index sometime in 2022 as much of preparatory work has already been done. 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. (Refer Will Foreigners Bond with India)
Divergent Yield Curve and Return Expectations.
Markets have a tendency to run ahead of actual events.
Since the start of 2021, bond yields have already risen a lot in expectation of
liquidity tightening and eventual rate hikes. Thus, gradual rate
increases which are well communicated will be absorbed comfortably. However, we
may continue to see a gradual increase in short term yields as central banks
increase rates and reduce liquidity.
Chart – V: Rate Hike Expectation Pushed Bond Yields Higher in 2021
Source
– Bloomberg, Quantum Research, Data upto December 20, 2021
Past Performance may or may not sustain in future
Long term bond yields
may remain range-bound around current levels or move up only marginally as we
expect this rate hiking cycle to be much shallower with the RBI trying to keep
the terminal repo rate closer to 5.0%-5.5% (Refer Investing in
The New Normal ). 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.
Long-term bond yields, though,
face risks from a sudden change in stance from central banks. India faces this
risk from an increase in oil prices or a rise in food prices. This would force
the RBI to hike interest rates sharply and markets could face higher
volatility.
With the RBI hiking the policy
repo rates and withdrawing its liquidity support to the market, money market
rates should rise.
Chart – VI: Short term interest rates to move higher
Source: Refinitiv, Quantum Research, Data
as of November 30, 2021
Past Performance may or may not sustain in future
2020 and early parts of 2021 saw
returns on medium to long-term bonds/bond funds soaring as interest rates fell.
At the same time, returns on overnight, liquid, money market funds fell.
The best way to play the rate hiking cycle is to focus on
the short maturity segments of the market. Investors in liquid funds and money
markets funds should see their returns improve as compared to bank savings
accounts. Low market risk, cash equivalents seem to be the best option from a risk/return
perspective.
Portfolio Allocation - Defensive and Dynamic
Although the macro backdrop is unfavourable
(high inflation, monetary tightening), valuation in 2-5 years government bonds looks
comfortable. In our opinion, this segment is already pricing much of the liquidity
normalization (lowering of liquidity surplus) and a start of the rate hiking
cycle by early next year.
Given the steep bond yield curve,
2-5 years bonds also offer the best roll-down potential and thus a reasonable margin of safety from
rising bond yields. For instance, currently, the yield on the 5 years
government bond is around 5.80% and that on the 4 years bond is at 5.58%. After
one year, the current 5-year bond will have a residual maturity of 4 years.
Assuming no change in market interest rates, the yield on the current 5-year
bond should roll-down by 22 basis points to 5.35% in one year period.
The bulk of our holding in the Quantum Dynamic
Bond Fund is in the 2-5 years maturity segment.
We recognize that the
monetary policy is in a transition phase in India and across the world. If
history is any guide, these transitions from easing to tightening monetary
policy tend to become chaotic with a lot of sentimental and divergent market
movements on both sides. Thus, we should be prepared for increased volatility
in the bond market over the next few months. With this view, we are
carrying higher than usual cash in the Quantum Dynamic Bond Fund portfolio to
lower the impact of any adverse market movements.
We are closely monitoring the
developments around the new Covid-19 variant and its impact on the monetary and
fiscal policies. We stand vigilant to react and change the portfolio
positioning in case our view on the market changes.
From investors’ perspective, we
believe a combination of liquid to money market funds to benefit from the
increase in interest rates in the coming months; along with an allocation to
short term debt funds and/or dynamic bond funds with low credit risks should
remain as the core fixed income allocation.
We suggest bond fund investors to have a longer holding period to ride through any intermittent turbulence in the market[MS1] .
This article will help raise money for everyone .
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