Bond yields are surging-what should investors do?
In the last month’s edition of the
Debt Market Observer – Inevitable Pivot, we cautioned that “The path
forward for bonds is filled with uncertainties….there will be surprises, there
will be miscommunications and there will be market overreactions.”
We witnessed some of that in the last two weeks.
The RBI surprised the market with an off-schedule 40 basis points hike
in the policy Repo rate (Rate at which banks borrow from the RBI.). The Repo
rate now stands at 4.40%. It also raised the Cash Reserve Ratio (CRR - portion
of deposits banks have to keep with the RBI as reserves) by 50 basis points
from 4.00% to 4.50%.
Expectations Reset
After the April monetary policy, rate hikes looked imminent. The bond market
prepared itself and priced for higher rates. The interest rate swap curve was
pricing for more than 200 basis points of a cumulative rate hike, before the
RBI’s announcement.
Yet, after the announcement bond yields shoot up and prices dropped. The
10-year government bond yield rose 26 basis points in intraday trade after the
policy announcement. 3-5 year bonds sold off even more with over 33 basis
points intraday jump in yields.
So, why this market reaction?
There are nuances in this policy announcement that changed the market reading
of the RBI.
The RBI chose to -
ü hike rate out of schedule; that
too just a few hours before the US federal reserve’s policy
ü hike by 40 basis points not
the conventional 25 basis points
ü raised CRR to absorb excess
liquidity
These should be seen together with
the April monetary policy move. In April the RBI introduced Standing Deposit
Facility (SDF) as a tool to absorb excess liquidity from the banking system.
The SDF rate is set at 25 basis points below the Repo rate.
This itself was equivalent to a 40 basis points hike in the marginal overnight rate as the floor monetary policy rate moved up from the reverse repo rate of 3.35% to the SDF rate of 3.75%. Now, with a 40 basis points hike in the repo rate, the SDF rate is set at 4.15%. This implies a cumulative 80 basis points rate hike in 4 weeks.
Chart – I: Money Markets moved up rates shoot up on surprise RBI hike and liquidity tightening
Source – Reserve Bank of India, Bloomberg,
Quantum Research; Data up to May 9, 2022
Past performance may or may not sustain
This shows a sense of urgency within
the RBI to unwind the ultra-easy monetary policy of low rates and high surplus liquidity,
quickly. There was also a realization that the RBI will not be hesitant to use
‘surprise’ as a policy tool.
Given the inflation uncertainty and
the fact that RBI is behind its peers in unwinding the pandemic stimulus, the urgency
to act is justified.
In his media statement, RBI Governor
Shaktikanta Das said – “There is the collateral risk that if inflation
remains elevated at these levels for too long, it can de-anchor inflation
expectations which, in turn, can become self-fulfilling and detrimental to
growth and financial stability.”
Clearly, the RBI has joined other global central banks in the war against inflation. We expect that the RBI would frontload the rate hikes with another 75-100 basis points hike by the year-end.
Not Too Far
The next question is - how far
will the RBI go?
The rate hiking cycle has just
begun. It’s too early to frame any clear view about the total quantum of rate
hikes or the terminal policy rate.
However, there are evidence
suggesting that the rate tightening cycle may not be too long this time (refer Investing In The New Normal).
Much of the inflation we see is the result
of supply chain bottlenecks. Russia Ukraine conflict has pushed prices of many
commodities across the food and fuel basket spiraling up to multi-year high.
Global trade is also disrupted due to the pandemic which is causing artificial
shortages of many key inputs.
These supply-side pressures have
pushed the CPI inflation to 7% in March 2021. Although this is above the RBI’s 6%
upper threshold, it is not too far when compared to the inflation situation in
many advanced economies.
Chart –II: Elevated Inflation to force RBI into hiking interest rates
Source – Mospi, Quantum Research; Data as of
March 2022.
Past Performance may or may not sustain
Monetary policy has a limited role
in tackling this supply-side ‘cost push’ inflation. As the supply chain
bottlenecks ease, inflation would soften quickly.
Demand-side of inflation is still
relatively weak. To recall, the Indian economy was not in good shape before it
got hit by the Covid-19 pandemic. GDP growth had slowed down to multi-year low
amid weak demand, high unemployment, and a credit freeze.
Unlike many advanced economies, our post-pandemic
direct fiscal support was significantly lower. Although the economy rebounded
quickly, the underlying demand condition is still weak due to income and job
losses.
Chart –III: Weak Employment and Income Loss Continue to
Cloud Demand Outlook
Source – Mospi, Quantum Research; Data as of March 2022.
Year on year GDP growth looks high
due to the lower base effect; while in absolute terms, GDP is far from its
pre-pandemic trend. The weakness can also be seen in the employment data and
demand for various goods and services.
Chart – IV: Real GDP is Still Below Pre-Pandemic Trend
Source – Mospi, Quantum Research; Data as of March 2022.
Given the weak consumer demand and fading growth momentum, RBI may not be able to hike too much. We expect the terminal repo rate (peak rate) in this hike cycle to be below 6%.
Liquidity Conundrum
On the policy rates, RBI’s actions
are somewhat in line with their commentary in the April monetary policy. While
the hike in cash reserve ratio (CRR) is little confusing given the RBI’s
earlier guidance of gradual withdrawal of liquidity over a
multi-year time frame.
CRR hike of 50 basis points will
take away around Rs. 870 billion of excess liquidity in one shot. Apparently,
RBI is not comfortable with the current level of excess liquidity persisting
for very long.
In his statement governor said – “Liquidity
conditions need to be modulated in line with the policy action and stance to
ensure their full and efficient transmission to the rest of the economy.”
This implies that the RBI will
continue to reduce the surplus liquidity along with the rate hikes to ensure
transmission of higher rates into the economy.
However, overall liquidity may remain in surplus to support the credit
offtake and economic growth momentum.
The
Governor said – “the RBI will ensure adequate liquidity in the system to
meet the productive requirements of the economy in support of credit offtake
and growth.”
As on May 9, 2022, the surplus
liquidity parked under the RBI’s variable rate reverse repo (VRRR) and SDF
windows is around Rs. 6 trillion (3.5% of NDTL). [refer Chart – I]
As the RBI Report on Currency and Finance for the year 2021-22, when surplus liquidity persists at above 1.5% of NDTL, for every percentage
point increase in surplus liquidity, the average inflation could rise by about
60 basis points in a year.
So, in an inflationary environment,
the RBI would bring down the liquidity surplus to below 1.5% of NDTL. Based on the
current Net Demand and Time Liabilities of the banking system the upper
threshold on surplus liquidity would be around Rs. 2.5 trillion.
Thus, we should expect further liquidity absorption to the tune of Rs. 3.5 trillion over the coming months. We would not be surprised if the RBI hikes the CRR by another 50 basis points in the June meeting. We should also consider a possibility of bond and/or foreign exchange sales to drain out liquidity.
Market Outlook - Uncertainty vs
Valuation
The bond market is having a
turbulent year 2022 so far. It faced back-to-back shocks from hawkish central
banks’ commentaries around the world, the geo-political conflict between Russia
and Ukraine, a spike in crude oil prices, global food shortages and price spike,
and further breakdown of global supply chains.
In India, Monetary Policy made a
complete U-turn from ultra-dovish in February to a surprise rate hike in May.
All this combined pushed up bond
yields to their 3-year highs. Since the start of the year 2022, the 10-year
government bond yield has risen by ~100 basis points while the 5-year yield has
increased by ~140 basis points.
Since Last month alone, 10 year
yield is up by 63 basis points and 5 year yield is up by 117 basis points.
Chart – V: Bond Market Front Running RBI’s Rate Hikes
Source – Refinitiv, Quantum Research; Data as
of May 9, 2022
Past Performance may or may not sustain
Currently, the 10-year government
bond is trading at a yield of 7.47% while the 5-year bond is trading at 7.27%.
Most of the medium to long-duration bonds are trading at a yield higher than
their pre-pandemic levels when the repo rate was at 5.15%.
Chart – VI: Yield Curve Shifted Up; Steepness Persist
Source – Refinitiv, Quantum Research; Data as
of May 9, 2022
Past Performance may or may not sustain
With the recent sell-off valuations
have become even more attractive. The 10-year bond yield level of ~7.4% was
last seen in early 2019 when the repo rate was at 6.5%.
The spread of the 10-year over 1-year government bond yield is currently at 200 basis points. This is more than double its 20-year average of 84 basis points. At current yield levels, much of the rate hike is already priced in the medium to long-duration bonds.
Chart – VII: Term Spreads are widest in more than a decade
Source – Refinitiv, Quantum Research; Data as
of May 9, 2022
Past Performance may or may not sustain
So, it would be reasonable to assume that the medium to long-term bonds would not be too sensitive to the rate hikes by the RBI, which are only normalization of the crisis time monetary policy.
Instead, what we worry about are –
-
the severe demand-supply gap in the domestic
government bond market, given the sharp jump in government bond supply to Rs.
15 trillion in FY23,
-
geopolitical uncertainty and its impact on global
supply chains and commodity prices especially crude oil, and
- the pace and extent of rate hikes and balance sheet reduction by the US Federal Reserve.
We reiterate that the path forward
for bonds is filled with uncertainties. Things are still evolving on the
geopolitical front and the unwinding of ultra-easy monetary policy has just
started. So, there will be surprises, there will be miscommunications and
there will be market overreactions.
Given the market pricing of aggressive rate hikes, there is an equal possibility of both positive and negative surprises in the next 2-3 quarters.
Portfolio Positioning
In the Quantum Dynamic Bond Fund, we
have been avoiding long-term bonds for some time due to our cautious stance on
the markets. The defensive positioning helped the portfolio ride through the
market sell-off over the last three months.
After the steep sell-off in the last
two months, valuations have become even more attractive on medium to long-term
bonds. However, given the high uncertainty as mentioned above, we will continue
to be cautious in adding into long-duration bonds as a core portfolio position.
We are still holding a significant
cash position which we will deploy tactically depending on market opportunities.
For the core portfolio, we continue to like the 4-5 years maturity bonds which
in our opinion, offer the critical balance between duration and accrual yield.
We would remain open and nimble to
exploit any market mispricing by making a measured tactical allocation to any
part of the bond yield curve as and when the opportunity arises.
We stand vigilant to react and change the portfolio positioning in case our view on the market changes.
What should Investors do?
In an environment of high uncertainty, it would be prudent for investors to avoid excessive credit and interest rate risk.
In
our opinion, a combination of liquid to money market funds and short-term debt
funds, and/or dynamic bond funds with low credit risks should remain as the
core fixed income allocation.
After more than a 100 bps sell-off in the bond market over the last
year, the return potential of debt funds has improved significantly. However,
it would not be a smooth ride as markets will continue to have bouts of
volatility.
We suggest bond fund investors have a longer holding period to ride through any intermittent turbulence in the market.
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