The FED, the RBI and Mr. Bond
“If there was incarnation…I would like to come back as the bond market.
You can intimidate everybody”.
James Carville (Advisor to former US
president Bill Clinton) must have said this as a joke. But, the movement in the
bond markets over the past two months have really been intimidating for
everyone from policy makers to investors. British government’s U-turn on the
tax cut proposal after bond sell off is a live testimony of this.
Bond yields have
been rising for the last two years. But, its sharp up move in the last two
months have been particularly destabilizing for markets. Over the last two and
half month (since July 31, 2022 till October 18, 2022), the 2 year US treasury
yield has moved up by 154 basis points
from 2.89% to 4.43%. Bond yield in other advanced and emerging economies have
followed the US treasury yields.
In advance
economies, these level of interest rates have not been seen for very long time.
This is an unknown territory for many of the financial models built on the last
10-15 years of market data. Financial system is becoming increasing sensitive
to interest rates beyond a level.
Chart – I: Sharp increase in DM bond yields threatening financial stabilit
Source
– Bloomberg, Quantum Research, Data as of October 18, 2022
Past performance may or may not sustain in future
FED’s dilemma
The US FED and
many other central banks in advanced economies are laser focused on controlling
inflation. They are hiking interest rates and unwinding liquidity support at a
historic pace.
The aggressive pace of rate hikes
and even more aggressive communication regarding its future path are making
everyone nervous around the globe. Uncertainty about the future economic
outlook has increased meaningfully and the financial system has become
extremely fragile.
The major concern at this point
is – for how long financial system can sustain this accelerated
tightening without causing any major accident?
Currencies across developed and
emerging markets have been falling sharply against the US Dollar. This makes
everything from energy to debt servicing costlier for a large part of the
world.
Chart – II: Hawkish US Fed and Rising Dollar putting pressure on currencies globally
Source
– Bloomberg, Quantum Research, Data as of October 18, 2022
Unlike previous crisis, this time
hypocenter of market turbulence is in advanced economies. Emerging Market pack
as whole has been relatively less impacted till now. But its vulnerability is
increasing every passing day.
Investors have withdrawn more
than USD 70 billion from emerging market debt funds so far in 2022. With
soaring interest rates in the developed world, many emerging economies may find
it difficult to rollover their external debt. At the same time, foreign
exchange reserves are depleting fast.
Financial markets are edgy. Margin
call on UK pension funds, trading
freeze in Japanese government bonds, falling
liquidity in the US treasury markets etc. are signs of brewing financial
market crisis.
Chart – III: Reducing Market liquidity hints a rising financial market risk
Source – IMF Global Financial Stability Report – October 2022
Can central banks ignore
financial stability risk?
History suggests they can’t.
Financial markets can have
serious effects on the functioning of the global economy. Worst of the economic
crisis from the Great Depression of 1929-39 to the Great Recession of 2007-09,
have emanated from financial market collapse.
“Regarding the Great Depression, … we did it.
We’re very sorry. … We won’t do it again.”
—Ben Bernanke, November 8, 2002
Over the years, Financial
Stability became an unsaid goal of every central bank more so for the US
Federal Reserve. In the past decade, the fed intervened at every hint of market
turbulence.
We are
once again at a tipping point. Monetary policy works with a lag of 6-9 months.
Impact of recent rate hikes and liquidity tightening may not be seen
immediately. So, front loading rate hikes too much, will increase a risk of
over doing.
In
words of International Monetary Fund (IMF) - “The risk of monetary,
fiscal, or financial policy miscalibration has risen sharply amid high
uncertainty and growing fragilities”.
Given the elevated inflation, the
FED would not be too sensitive to falling asset prices. Rather, they would like
lower asset prices as it could help in lowering inflation momentum through
negative wealth effect. But it would be difficult for them to ignore market dysfunctioning.
Even its inflation objective
cannot be achieved without a support from the market. Turbulence in the
financial markets can limit their ability to go after inflation by forcing it
to readjust the monetary policy.
The biggest risk central banks
face at this moment is that they may have to stop tightening before getting
inflation under control. Thus, we may see financial stability discussion taking
a centre stage in the policy setting going ahead.
A glimpse of this can be seen in
UK where the Bank of England has to temporarily pause its quantitative
tightening program and start buying bonds to stabilise the market.
In order to strike a balance between the two objectives of inflation and financial stability, the Fed will have to re-calibrate the pace of rate hikes and liquidity unwinding with due consideration to financial stability risks.
Where does India stand in all
this?
In 2022 so far, the INR has
fallen by 11.8% against US Dollar, from ~INR 74/USD at the start of the year to
around INR 83/USD at the time of writing this report on October 19, 2022.
RBI’s Foreign exchange reserves
have fallen by more than USD 100 billion over the last 12 months. As per the
RBI, two third of this decline was due to revaluation of reserves maintained in
other currencies, and the remaining one third of decline is due to sale of
forex reserves by the RBI to protect the Rupee from falling too sharply.
As per the latest available data
for October 7, 2022, RBI’s foreign exchange reserve stands at USD 532.8
billion. This still provides the RBI sufficient fire power to curtail sharp
volatility in INR. Nevertheless, sustained rise in Dollar will continue to put
pressure on the INR.
Chart – IV: RBI’s FX reserve is falling though still remain reasonably high
Source – RBI, Quantum Research, Data as of October 18, 2022
The monetary policy debate within
the RBI has already shifted from inflation to external risks. Inflation, though
still above the RBI’s upper threshold of 6%, is expected to come down
gradually. But, a mix of high crude oil prices and wide current account deficit
is making India vulnerable to global shock.
If Fed slows down, it would be
a shy of relief for the RBI as well. It will allow the RBI to focus on domestic
growth inflation dynamics.
From domestic macro stand point,
the monetary policy cycle is nearing its peak. The RBI has frontloaded the
monetary policy tightening with - (a) 190 basis points increase in the repo
rate; (b) 230 basis points increase in the floor policy rate (Reverse
Repo/SDF); and (c) reduction in core liquidity surplus by around Rs. 7 trillion.
Effective overnight rates
represented by overnight Tri-Party Repo rate has increased by over 280 basis
points from 3.25% at the start of the year to around 6.10% now.
Chart – V: RBI’s aggressive rate hikes and liquidity reduction has pushed interest rate highe
Source – RBI, Quantum Research, Data upto October 7, 2022
Impact of these rate hikes and
liquidity tightening will be seen in the real economy over the next 3-4
quarters. In principle, monetary tightening should slowdown demand and put
downward pressure on inflation.
Although Indian economy is
recovering at a steady pace, it is still growing below its potential and remain
well below the pre pandemic trend. Tightening global financial conditions and
recessionary fears in advanced economies will also be drag on growth.
Given the significant
frontloaded tightening in monetary policy and fragility of economic growth,
there is a case for the RBI to slowdown or even pause.
Some of the monetary policy
committee members also presented a case for the RBI to adopt a more calibrated
approach going forward.
Dr. Ashima Goyal in her remarks
mentioned - “If lagged effects of monetary policy are large, as in India,
over-reaction can be very costly. Harmful effects become clear too late and are
difficult to reverse.” She added “High uncertainty also calls for
slow steps.”
Prof. Jayanth Verma said - “It
is dangerous to push the policy rate well above the neutral rate in an
environment where the growth outlook is very fragile.”
In our opinion, the RBI will be
more data dependent and will likely slow down the pace of tightening. The Repo
rate may peak somewhere between 6.0%-6.5%.
How will it affect the Indian
bond market?
The bond market is already
pricing for a terminal repo rate of 6.5%. So, another 25-50 basis points rate
hike will not impact market prices in any material way.
Much of the macro worsening has
already happened and it is now part of collective market psyche. We have
already seen the worst of inflation. Much of rate hikes have already happened.
The peak of central banks’ hawkishness is now behind us.
It is a time we should look
beyond the market noises and spot the emerging trend.
After recent sell off, bond
valuations have improved. Currently, the 3-5 years government bonds are trading
at yield of between 7.30%-7.45%. This is more than 140 basis points above the
repo rate of 5.9%. The long-term average of this spread in a tightening
interest rate environment is around 80-90 basis points.
As the monetary policy
stabilises, yield spread between long term bonds and the repo rate should
compress. So, we see limited upside on yields from here.
Entire bond yield curve is now
trading at a yield above the expected CPI inflation.
Chart – VI: The real rate is positive across the yield curv
Source – Refinitiv, Quantum Research, Data as of October 18, 2022
We expect bond yields to move
sideways in a tight range with the 10 year Gsec yield trading between 7.2%-7.6%.
While Short term money market rates will move higher along with the policy repo
rate.
Considering the duration-accrual
balance, 3-5 year segment remains the best play as core portfolio allocation.
However, valuation at the longer end bonds upto 10 year have also turned
attractive after recent sell off.
What should Investors do?
We suggest investors with 2-3
years holding period should consider adding their allocation to dynamic bond
funds.
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 over the next 2-3 years.
Dynamic bond funds have
flexibility to change the portfolio positioning as per the evolving market
conditions. This makes dynamic bond funds better suited for the long-term
investors in this volatile macro environment than other long term bond fund
categories.
Investors with shorter investment
horizon and low risk appetite should stick with liquid funds. With increase in
short term interest rates, we should expect further improvement in potential
returns from investments in liquid going forward.
Since the interest rate on bank
saving accounts are not likely to increase quickly while the returns from
liquid fund 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.
Portfolio Positioning
Scheme
Name |
Strategy |
Quantum
Liquid Fund |
The scheme continues to invest in debt securities of
upto 91 days maturity issued by the government and selected public sector
companies. |
Quantum Dynamic Bond Fund |
The scheme continues to invest in debt securities
issued by the government and selected public sector companies. The
scheme follows an active duration management strategy. Based on
our market outlook, we continue to prefer 3-5 year government bonds as a core
allocation in the scheme. |
Discaimer, Statutory Details & Risk Factors:
The views expressed here in this article / video
are for general information and reading purpose only and do not constitute any
guidelines and recommendations on any course of action to be followed by the
reader. Quantum AMC / Quantum Mutual Fund is not guaranteeing / offering /
communicating any indicative yield on investments made in the scheme(s). The
views are not meant to serve as a professional guide / investment advice /
intended to be an offer or solicitation for the purchase or sale of any
financial product or instrument or mutual fund units for the reader. The
article has been prepared on the basis of publicly available information,
internally developed data and other sources believed to be reliable. Whilst no
action has been solicited based upon the information provided herein, due care
has been taken to ensure that the facts are accurate and views given are fair
and reasonable as on date. Readers of this article should rely on
information/data arising out of their own investigations and advised to seek
independent professional advice and arrive at an informed decision before
making any investments.
Risk Factors: Mutual Fund investments are
subject to market risks, read all scheme related documents carefully.
No comments:
Post a Comment