Let’s Bond with Bonds
In the June 2022 edition of the Debt Market Observer –
Looking Beyond FED, we made a case that the inflation narrative has peaked. Market developments
since then have made us more convinced about the endgame of inflation.
Commodity Crack
Commodity prices have been softening for the last 2-3
months due to moderation in the global growth outlook. Lockdown in China and fear
of recession in the US and Europe accelerated the pace of decline in the last 4-6
weeks. Prices of most of the industrial as well agricultural commodities are
down upto 50% from their recent peaks.
Table – I: Commodities off-peak on recession fears
|
|
% Price Change from
the Peak |
% Price Change year
till date |
|
Thomson
Reuters Core Commodity CRB Index |
-13% |
23% |
|
S&P
GSCI Agriculture Index |
-22% |
7% |
|
Brent
Crude Oil |
-17% |
37% |
|
Bloomberg
Industrial Metals Subindex |
-39% |
-16% |
Source – Bloomberg, Quantum Research, Data as of July
18, 2022
Our inflation estimates were not based on the highest
level of commodity prices, so this drop in prices may not materially change the
inflation numbers immediately. However, the upside risk to the inflation estimate
this year has gone down significantly.
If commodities prices stabilize, India’s CPI inflation
should come below the RBI’s upper threshold of 6% by early next year from the current
7% plus. Given the synchronized global monetary tightening and slowing global
growth, this seems the most plausible outcome.
Monsoon on Track
Domestically also things have improved for inflation
to cool off. After initial delays, the monsoon has now picked up. Total
rainfall between June 1, 2022 to July 18,
2022 is 13% above the long term average rainfall during this period. However, the
spatial distribution of monsoon is a bit concerning as the monsoon activity is
concentrated in the western and southern regions of the country while the north
and east parts are still in deficiency.
Table – II: Total rainfall in surplus; but spatial distribution is poor
Source – India Meteorological Department; data as of July 18, 2022 (https://mausam.imd.gov.in/imd_latest/contents/weather_report.php)
The sowing
of kharif crops has also picked up along with the southwest monsoon; though
total acreage is still lagging in Rice compared to its last 5 years’ trend. Much
of the rainfall in the current monsoon season has come in the last two weeks.
So, the sowing activity should pick up sharply from here on.
Table – III: Kharif sowing picked up; still lagging in Rice
|
Crop |
Normal
Kharif Sowing Area (In Million Hectares) |
Area Sown (In Million Hectares) |
||
|
2022 |
2021 |
% Year-on-Year Change |
||
|
Rice |
39.7 |
12.8 |
15.6 |
-17.9% |
|
Pulses |
14.0 |
7.3 |
6.7 |
9.0% |
|
Course-cum-Nutri Cereals |
18.4 |
9.4 |
8.7 |
8.0% |
|
Oilseeds |
18.4 |
13.4 |
12.5 |
7.2% |
|
Sugarcane |
4.7 |
5.3 |
5.4 |
-1.9% |
|
Jute & Mesta |
0.7 |
0.7 |
0.7 |
0.0% |
|
Cotton |
12.6 |
10.3 |
9.7 |
6.2% |
|
Total |
108.5 |
59.2 |
59.3 |
-0.2% |
Source – GOI Department of Agriculture & Farmers Welfare; Data as of July 8, 2022 (https://agricoop.nic.in/en/weather-watch)
Globally,
agricultural commodity prices have started to soften. A healthy monsoon
season should help in easing food prices in the domestic market as
well.
Government’s
inflation fight
Another
notable development during the last one month is the government’s move to
impose export duties on petrol and ATF at the rate of Rs. 6/litre each and on
diesel at the rate of Rs. 13/litre. It also slapped a windfall tax on domestic
crude production of Rs. 23,250 per tonne. This would discourage the export of petroleum
products and increase the fuel supply in the domestic market.
These measures are estimated to
generate Rs. 1.2 trillion in government revenues which could be used to further
reduce taxes on fuel items - effectively putting a cap on the petrol and diesel
prices or even cutting their prices.
Indian CPI basket has close to 5%
weight in petroleum fuel items and around 46% weight in food items. Thus, a reduction
in food and fuel prices could sharply bring down the inflation.
Inflation losing Momentum
In June 2022, CPI inflation grew at 7.01% YoY, posting
the third consecutive month of decline in the headline CPI from 4.05% in May
2022 and 4.8% in April 2022. We found some green shoots in the inflation
internals.
Sequential momentum across various high-weightage
items like Cereals, Meat & Fish, Spices, Prepared meals and clothing &
footwear have softened in June. Prices of Oil &
Fats came down due to a drop in global edible oil prices and a reduction in
import duties by the Government. While the transport and communication index
came down due to an earlier reduction in fuel taxes. Another positive sign was the
moderation in the sequential momentum in some of the key services like health
care and recreation.
We
expect the headline CPI inflation to move up again between July – September
2022 due to the lower base effect from the last year and a seasonal uptick in
the vegetable and fruit prices. However, it should come down sharply in the
second half of the year.
In the August meeting
of the RBI’s monetary policy committee, it may deliver another 50 basis points
of rate hike to take the repo rate above its pre-pandemic level to 5.40%.
However, easing of inflation momentum should take off some pressure and allow
the RBI to slow down the pace of rate hikes in the second half of the year. The RBI may still take the Repo rate to
5.75%-6.00% by early next year to take the short-term real interest rates into
positive territory.
Chart -I: Inflation Elevated; But Likely to Slide Lower
Source – MOSPI,
Quantum Research
@Actual Data upto June 2022. Data between July 2022 to December 2022 is based on Quantum Fixed Income Team’s Estimates and may or may not turn out the same.
What does
this mean for the Bond Market?
Bond
yields have come down sharply in the last 4-5 weeks in response to falling
commodity prices and falling US Treasury yields. The 10-year Indian
government bond yield peaked at 7.60% on June 13, 2022. Currently, on July 18,
2022, the 10-year Indian government bond is trading at a yield of 7.44%.
Chart – II: Moderating Commodity Prices to Cap Indian Bond Yields
Source – Refinitiv, Quantum Research; Data as of July
18, 2022
Past Performance may or may not sustain
Last month, we wrote to investors that the prevailing
valuations at the medium to long maturity bonds had built in a significant
uncertainty premium (Looking Beyond FED). The recent drop in the bond yields and the consequent compression of
yield spread on medium to long duration bonds over the repo rate, has lowered
the uncertainty premium somewhat.
However, term spreads (yields on long-term bonds over
shorter maturity bonds or the repo rate) are still significantly higher than
their long-term averages. At 6.88% yield, the 3-year government bond is currently trading at about 200
basis points above the policy repo rate of 4.90%. The long-term average of this
spread in a tightening interest rate environment is ~80 basis points.
Chart – III: Yield Spreads over Repo Rate are significantly above their long term averages – pricing for potential rate hikes, demand-supply imbalance and other uncertainties.
Source – Refinitiv, Quantum Research; Data as of July
18, 2022
Past Performance may or may not sustain
Chart – IV: Bond Valuations have built-in significant
uncertainty premium
Source – Refinitiv, Quantum Research; Data as of July
18, 2022
Past Performance may or may not sustain
Even in terms of real rates (interest rates/bond
yields – expected inflation rate), the yield on government bonds beyond 1 year maturity
is now above the average 12 months’ forward inflation
estimate. Our estimate of 12 months average forward inflation (simple average
of expected monthly inflation estimates from July 2022 till June 2023) is
around 6.2%.
Chart –V: Real rates are now in positive territory beyond 12 months term
Source – Refinitiv, Quantum Research; Data as of July
18, 2022
@ Real rates are calculated based on forward 12
months CPI inflation as per the Quantum Fixed Income Team’s Estimates; Future
estimates may or may not turn out the same.
Past Performance may or may not sustain
Outlook
Markets
tend to pre-empt policy moves. Yields on medium to long term bonds had moved up
over the last 12 months to price for the rising inflationary risks and
potential rate hikes by the RBI.
At
current valuations, much of the potential rate hikes are already priced in the
medium to long duration bonds. Thus, the bond market may not be too sensitive to RBI’s rate
hikes going forward.
As the RBI delivers on the expected
rate hikes, short-term interest rates – yield short-term treasury bills etc.
should move higher proportionately. However, long term bond yields may remain
in a tight range or move up only marginally.
We
found a similar trend in past. In all the previous rate hiking cycles, maximum jump
in yields had happened up until the first-rate hike. Thereafter, yields moved
up only marginally or got stuck in a narrow range.
Chart – VI: Bond Market has run ahead of the Policy rates; Much of the potential Rate Hikes are already Priced
Source – Refinitiv, Quantum Research; Data as of July
18, 2022
Past Performance may or may not sustain
There is still a risk of yields moving up due to an unfavorable
demand-supply balance. Long-term bonds (above 5 years maturity) are more
exposed to this risk as their prices are more sensitive to interest rate
changes. When market interest rates rise, long term bond prices fall more compared
to prices of shorter maturity bonds.
Since we are in a rising interest rate environment, at this stage our goal should be to
have higher accrual with a lower maturity/duration. In our opinion 2-5 year maturity
bonds offer this critical balance between accrual (interest income) and duration (price changes).
Portfolio
Positioning
In
the Quantum Dynamic Bond Fund (QDBF), 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 6 months.
The
bulk of the QDBF portfolio is currently positioned in the 1-3 years maturity
bonds. We continue to like the 2-5 year segment of the bond market and maintain
our cautious stance on the above 5-year maturity bonds.
However,
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?
The interest rate on short-term treasury bills has jumped
about 160 basis points (1.6%) in the last 6 months. With more rate hikes
coming, short-term treasury bill rates are expected to move higher in the coming
months. This suggests higher potential returns from investments in liquid and
debt funds going forward.
Since the interest rate on bank saving accounts are not
likely to increase quickly while the returns from liquid funds are already
seeing an increase, investing in liquid funds looks more attractive for your
surplus funds. Investors with a short-term investment horizon and with little
desire to take risks should invest in liquid funds which own government
securities and do not invest in private sector companies which carry lower
liquidity and higher risk of capital loss in case of default.
Investors with more than 2-3 years
holding period can consider dynamic bond funds which have the flexibility to
change the portfolio positioning as per the evolving market conditions.
Medium to Long term interest rates in
the bond markets are already at long-term averages as compared to fixed
deposits which remain low. With higher accrual yield (interest income) and
relatively lower price risk (compared to the last two years), dynamic bond
funds are appropriately positioned to gain.
However, investors in debt fund
dynamic bond funds or any other medium to long-term debt funds should be ready
to tolerate some intermittent volatility associated with the movement in the
market interest rates.
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