FED, Liquidity and Rain
“In the world of investing, perception often swings from flawless
to hopeless”
This quote
by Howard Marks, aptly portrays the changes in market narratives over the last few
months. In the US, the bond market narrative has been toggling between two
extremes - “persistent high inflation” and “recession”.
This has
put the bond markets around the world on an emotional roller coaster. A month
back, the US treasury futures were pricing for two or more rate cuts. Now, the
expectation has shifted to two more rate hikes in 2023.
This has
not just pushed US treasury yields higher; but moved the sentiments in the Indian
bond market too; sometimes in contrast to the local developments. The 10-year Indian government bond (Gsec)
yield which had fallen to lows of 6.96% during early June, has jumped to the peak
of 7.17% before falling back to the current levels of 7.07%.
Chart – I: Indian bond yields has been tracking long term US treasury yields
Source –
Refinitiv, Quantum Research, Data as of Jul 20, 2023
Past Performance may or may not sustain
The US Fed
is expected to hike the Fed Funds rate by 25 basis points in its upcoming
review meeting on July 26th. This is already a part of market psyche.
Thus, the rate hike by itself is unlikely to have any material impact on the
markets. Instead, the bond market will closely follow the Fed’s language to
find cues about the future course of monetary policy.
We foresee
following possible outcomes:
|
Fed Decision |
Market Impact |
|
Hike by 25 basis Points + Hawkish tone indicating
more rate hikes to come |
Short term treasury rate will move up. However, long term rates might not move much as the
rate hiking cycle is near its end and tighter financial condition will
increase the probability of recession in the US. Indian yields share stronger linkages with the longer-term
treasury yields than shorter term USTs. Thus, this outcome is unlikely to
cause any material impact on the Indian bond market, though yields might move
up initially on the Fed’s hawkish stance. |
|
Hike by 25 basis points +Neutral to Dovish tone indicating
the rate hiking cycle is over |
Short term US treasury rate move up marginally,
while long term rates fall. Marginal decline in Indian Bond yields. |
|
No Rate hike + Cautious Tone |
This would indicate that the bar for rate hike is
very high, and the rate hiking cycle is over for now. Sharper down move in the long-term US treasury. Indian bond yields will come down though at a
moderate pace. |
Don’t miss
the wood for the trees.
The broader picture is that the rate hiking cycle is
near its end. One
or two tactical rate hikes by the US Fed cannot be ruled out. But these are
unlikely to have any lasting impact on the Indian bond markets.
At this juncture, we shall be focusing more on the domestic developments particularly around the inflation and liquidity
Shifting
Liquidity Dynamics
The less
talked aspect of the RBI’s monetary policy normalization last year, was its
covert tightening of liquidity condition. It reduced the durable liquidity
surplus from ~Rs. 11 trillion in December 2021 to below ~Rs. 3 trillion by
December 2022, and tightened further to below Rs. 1 trillion by April
2023.
Back in
April, we expected the core liquidity (Banks’ excess liquidity with the RBI+
government balance) to turn into deficit from May 2023.
But it
turned out differently in the last three months. The core liquidity increased
to surplus of over Rs. 3.7 trillion as per the latest available data for July 14,
2023. This was mainly contributed by – (1) deposit of Rs. 2000 currency notes after the
RBI’s announcement to withdraw it from circulation, and (2) Foreign Exchange
(FX) purchases by the RBI.
Since the
announcement of Rs. 2000 currency note withdrawal on May 19, 2023, the currency
in circulation (CIC) has declined by Rs. 1.26 trillion (as per the latest
available data on July 14, 2023). Typically, this used to be a calm period for
the CIC with no major changes. Thus, almost entire drop in CIC (increase in
banking system liquidity) can be attributed to the deposit of Rs. 2000 currency
notes.
On the FX
front, the RBI has been quite aggressive in rebuilding it reserves. It bought over
USD 15 billion of foreign exchange during April and May 2023. The FX buying
spree continued in June and in July so far. Our reverse calculation from changes
in liquidity condition during June and July, indicates additional USD 6 billion
FX purchases by the RBI. These FX purchases added around Rs. 1.7 trillion of
durable liquidity into the banking system.
Chart – II: Liquidity condition eased due to Rs. 2000 note withdrawal & RBI’s FX buying
Source – RBI, Quantum Research, Data as of Jul 14, 2023
The broader
view of dollar depreciation going forward and foreign investors rising interest
in Indian financial markets, support continuation of FPI inflows into the India
equity and debt markets. This would ease the liquidity condition even further.
From the
bond markets’ perspective, the impact of liquidity is two-fold:
(1) Easy liquidity condition brought down the short-term yields in the money markets. The yield on the 1-year treasury bill came down from 7.16% on March 31, 2023, to around 6.87% on July 20, 2023. During the same period, AAA PSU CDs witnessed around 23 bps drop in yields from 7.61% to 7.38%.
Given our view on liquidity, we expect money market rates to remain well anchored around the policy repo rate. This, in turn, might keep the front end of the yield curve steep.
Chart – III: Easy
liquidity condition to keep short term rates anchored around the Repo Rate
Source –
Refinitiv, Quantum Research, Data as of Jul 20, 2023
Past Performance
may or may not sustain
(2) Increased bank deposits have boosted banks demand for bonds. However, on the other hand, it has negated the possibility of OMO purchases by the RBI as expected by many market participants earlier. On net basis, demand supply looks in balance for this year.
All in all, easy liquidity condition is likely to remain supportive for the bond market keeping a lid on the bond yields.
Cloudy Foodflation
Monsoon came to India with a delay of at least
8 days; but picked up quickly. As per the latest available data on July 20,
2023, overall rainfall since start of the monsoon season stands at 3% higher
than the long period average (LPA).
However, the rainfall distribution has been
uneven with downpour in Northwest region (45% high than LPA) and severe
shortfall in East & Northeast (-21% lower than LPA) and South peninsula
(-17% lower than LPA).
Chart – IV: Total Rainfall above
Normal; but with uneven distribution
|
Region |
Actual |
Normal |
% Departure from Long Period Average |
|
EAST AND NORTHEAST INDIA |
481.8 |
610.7 |
-21% |
|
NORTHWEST INDIA |
297.8 |
206 |
45% |
|
CENTRAL INDIA |
404.1 |
369.5 |
9% |
|
SOUTH PENNINSULA INDIA |
241.7 |
290 |
-17% |
|
COUNTRY AS WHOLE |
351.9 |
342.1 |
3% |
Source – IMD, Data as of Jul 20, 2023
Source – IMD, Data as of Jul 20, 2023
Late arrival and patchy rain distribution
delayed the sowing of Kharif crops which were lagging to the extent of -23%
(compared to the area sown during corresponding period last year) for important
crops like cereals and pulses until July 3, 2023.
Since then, the sowing activity picked up
sharply along with the widening of monsoon coverage. As per the latest
available data on July 14, 2023, total area sown is down only -1.6% YoY as
against -5.4% a week back. We would expect further increase in the area sown
for most of the important crops over the coming two weeks.
Chart – V: Kharif sowing started
late but recovering fast
|
Progress of
Area Coverage under Kharif crops (% change over
corresponding period last year) |
||
|
Crops |
09-Jul-23 |
14-Jul-23 |
|
Rice |
-15.8% |
-6.1% |
|
Total Pulses |
-17.9% |
-13.3% |
|
Total Coase Cereals |
19.7% |
18.1% |
|
Total Oilseeds |
-10.2% |
1.7% |
|
Sugarcane |
4.7% |
4.7% |
|
Total Jute and Mesta |
-12.0% |
-7.8% |
|
Cotton |
-5.2% |
-11.7% |
|
Total |
-5.4% |
-1.6% |
Source – Agricoop, Quantum Research, Data as of Jul 14, 2023
Notwithstanding the sowing recovery, food
prices have started to move higher quickly. Sharp jump in vegetable prices led
by tomatoes captured everyone’s attention recently. This caused an upside
surprise of more than 20 basis points from the median market forecast in the
CPI inflation in June.
CPI inflation will face further upward pressure
during July – September quarter due to sharp jump in vegetable prices. However,
it should correct in the Q3 and Q4 in line with the seasonal trend in vegetable
prices.
More worrying trend though is the recent
increase in prices of rice and pulses which can contribute significant upside
to the inflation for a longer period. Any shortfall in the production of these
crops will be a key risk for the inflation outlook.
We would be closely monitoring the developments around
Kharif sowing and food prices over the coming weeks to affirm our inflation
outlook.
We opine this risk is not adequately factored in the bond valuations. Thus, we would prefer to take a cautious stance and wait for these risks to subside or valuations to correct.
Bond Outlook
Looking through all the near-term noises, the medium-term
outlook for bonds looks favourable supported by peaked policy rates, comfortable liquidity condition and
strong external position.
Given the stretched valuations and
near-term risk due to weak rainfall trend, we see a high possibility of long-term yields
moving higher from current levels in near term. However, the upside on yields
should be limited to 10-20 basis points given the overall macro backdrop is
favourable.
Market condition for short term
bonds have turned favorable with pause in rate hikes and prevailing easy
liquidity condition.
At this stage,
the 2-5 years maturity government bonds are attractively positioned with a
medium-term outlook.
In line with our near-term cautious view, we maintain a lower portfolio duration in our actively managed bond fund as a tactical position. However, we shall look to extend the portfolio duration in every market dip.
What should Investors do?
With
government bond yields above 7%, there is decent accrual available at current
levels. Even in the real term
(adjusted for inflation), government bonds are offering meaningful positive
real yield. With expected
CPI inflation of 5.1% (RBI’s FY24 inflation estimate) and a 1-year Gsec yield
at 6.9%, the real yield is around 180 basis points.
Investors with 2-3 years holding period can consider Dynamic
bond funds which have
flexibility to change the portfolio positioning as per the evolving market
conditions.
Investors with shorter investment horizons and low-risk appetites should stick with liquid funds.
Portfolio Positioning
|
Scheme Name |
Strategy |
|
Quantum Liquid Fund |
The scheme invests in debt securities of up to 91 days of maturity
issued by the government and selected public sector companies. |
|
Quantum Dynamic Bond
Fund |
The scheme to invest in debt securities issued by the government and
selected public sector companies. The scheme follows
an active duration management strategy and increases/decreases the portfolio
duration (sensitivity to interest rates changes) in accordance with the
Interest Rate Outlook. Given the near-term
uncertainties around food inflation, we are maintaining lower portfolio
duration than the benchmark in the scheme. However, we are ready to act
quickly to market developments and upcoming data points. |
Product Labeling
|
Name of the Scheme |
This product is suitable for
investors who are seeking* |
Riskometer |
|
Quantum Liquid Fund An Open-ended Liquid Scheme. A
relatively low interest rate risk and relatively low credit risk. |
|
Investors
understand that their principal will be at Low Risk |
|
Quantum Dynamic Bond Fund An Open-ended Dynamic Debt Scheme
Investing Across Duration. A relatively high interest rate risk and
relatively low credit risk. |
|
Investors
understand that their principal will be at Low to Moderate Risk |
* Investors should consult their financial advisers
if in doubt about whether the product is suitable for them.
|
Potential Risk Class Matrix – Quantum Dynamic Bond Fund |
|||
|
Credit Risk → |
Relatively Low |
Moderate (Class B) |
Relatively High (Class C) |
|
Interest Rate
Risk↓ |
|||
|
Relatively Low
(Class I) |
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|
Moderate (Class II) |
|
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|
Relatively High (Class III) |
A-III |
|
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|
Potential Risk Class Matrix – Quantum Liquid Fund |
|||
|
Credit Risk → |
Relatively Low |
Moderate (Class B) |
Relatively High (Class C) |
|
Interest Rate
Risk↓ |
|||
|
Relatively Low (Class I) |
A-I |
|
|
|
Moderate (Class II) |
|
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|
Relatively High (Class III) |
|
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Disclaimer, 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. Mutual fund investments are subject to market
risks read all scheme related documents carefu |
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