There are 2 components to what impact recent developments can have on the market:
1. What happens to RBI rate expectations: Market is likely to start anticipating a greater emphasis from RBI on mitigating external vulnerabilities and addressing current account risks. Also, the cumulative effect of currency depreciation may reduce the extent of inflation fall to some extent. Given these considerations, the market has already priced out a July rate cut expectation. The risk will be that if the current theme continues, participants may be forced to pare down future rate cut expectations as well. Importantly, this factor alone should impact those parts of the yield curve that are most sensitive to rate cut expectations today. For instance, government bond yields recently have been running on rate cut expectations alone and not worrying as much about the net supply of INR 150,000 crores plus that is due over the next 2 months or so. Should rate cut expectations get further dampened, the focus will shift to supply absorption and yields may start to drift higher. On the other hand, the „front end‟ of corporate curve (or for that matter the government bond curve) does not need near term rate cuts as the term spreads are already quite attractive.
2. The Current Account Deficit discussion may become a Balance of Payment debate: Thus far the RBI‟s concerns have been on vulnerabilities that may potentially arise owing to India‟s high current account deficit. Hence, a reduction in the CAD was conditionality for further meaningful rate cuts. Funding the CAD in the current environment was never perceived as an issue given the strong portfolio, ECB, and NRI flows that have been coming into the country. However, should the current global construct not improve, the concerns may shift towards financing the CAD. In other words, the worry may shift from a high CAD to a possible balance of payment (BoP) risk should it be deemed that capital flows may prove to be insufficient to fund the CAD. It has to be stressed here that given India‟s substantial forex reserves, there is no scope for a crisis on this account. What is only being debated here is whether policy concern will have to shift towards financing the CAD without touching our forex reserves. Should such concerns arise and become subject of generalized debate, then all parts of the yield curve can potentially come under pressure.
If investors agree with the above framework, this also gives clues towards portfolio strategy. If events change market‟s expectation of RBI rate cuts back towards bullishness, then it would make sense to start buying government bonds again. A clear trigger that can make this happen is that if a strong dollar and weak global growth start pulling oil prices down as well. If policy efforts can stabilize the rupee, that can cause a change in sentiment as well. Should such triggers not materialize, then our bias will be to wait for better risk premiums on the government bond curve that account for lack of near term rate cuts. Importantly, front end rates can be bought irrespective as long as the debate is only on whether RBI will cut now or not.
The second point about a BoP debate can be mitigated by visibility of flows. Should policy makers react with near term solutions like an NRI bond that can potentially solve the problem of flows and thus put the debate to rest; at least for some time. Alternatively, should the RBI manage to stabilize the rupee at some level, it may get FII interest back into the country and automatically put to rest the funding debate. Even though the potential disruption from point 2 above can be huge, our bias is to expect that this fear will not materialize. Either policy efforts or market forces or both should eventually lead to some currency stability (although at what level remains open for debate at this point). Hence, we continue to hold on to our front end rate positions. On the issue of point 1 above, there is a chance that market interest rate expectations may take time to settle. In the meanwhile, market will have to contend with weekly supply pressures on government bonds. For these reasons, we may add back government bonds (or the long end of corporate curve) more slowly waiting either for better pricing of risk premiums or some change back in market‟s forward rate expectations.
The recommendation to investors remains exactly the same. It is prudent to allocate 50% of new allocations to short and medium term funds, and the balance into dynamic and income funds. The rationale for this has been discussed before (refer “Recent market developments and investor takeaways”, dated 11th June for details). We continue to run dynamic and income funds actively in line with our evolving assessment of the macro-economic environment. At this juncture these funds are running conservative maturities and higher cash levels. We will look to increase maturities, based on triggers mentioned above.
1. What happens to RBI rate expectations: Market is likely to start anticipating a greater emphasis from RBI on mitigating external vulnerabilities and addressing current account risks. Also, the cumulative effect of currency depreciation may reduce the extent of inflation fall to some extent. Given these considerations, the market has already priced out a July rate cut expectation. The risk will be that if the current theme continues, participants may be forced to pare down future rate cut expectations as well. Importantly, this factor alone should impact those parts of the yield curve that are most sensitive to rate cut expectations today. For instance, government bond yields recently have been running on rate cut expectations alone and not worrying as much about the net supply of INR 150,000 crores plus that is due over the next 2 months or so. Should rate cut expectations get further dampened, the focus will shift to supply absorption and yields may start to drift higher. On the other hand, the „front end‟ of corporate curve (or for that matter the government bond curve) does not need near term rate cuts as the term spreads are already quite attractive.
2. The Current Account Deficit discussion may become a Balance of Payment debate: Thus far the RBI‟s concerns have been on vulnerabilities that may potentially arise owing to India‟s high current account deficit. Hence, a reduction in the CAD was conditionality for further meaningful rate cuts. Funding the CAD in the current environment was never perceived as an issue given the strong portfolio, ECB, and NRI flows that have been coming into the country. However, should the current global construct not improve, the concerns may shift towards financing the CAD. In other words, the worry may shift from a high CAD to a possible balance of payment (BoP) risk should it be deemed that capital flows may prove to be insufficient to fund the CAD. It has to be stressed here that given India‟s substantial forex reserves, there is no scope for a crisis on this account. What is only being debated here is whether policy concern will have to shift towards financing the CAD without touching our forex reserves. Should such concerns arise and become subject of generalized debate, then all parts of the yield curve can potentially come under pressure.
If investors agree with the above framework, this also gives clues towards portfolio strategy. If events change market‟s expectation of RBI rate cuts back towards bullishness, then it would make sense to start buying government bonds again. A clear trigger that can make this happen is that if a strong dollar and weak global growth start pulling oil prices down as well. If policy efforts can stabilize the rupee, that can cause a change in sentiment as well. Should such triggers not materialize, then our bias will be to wait for better risk premiums on the government bond curve that account for lack of near term rate cuts. Importantly, front end rates can be bought irrespective as long as the debate is only on whether RBI will cut now or not.
The second point about a BoP debate can be mitigated by visibility of flows. Should policy makers react with near term solutions like an NRI bond that can potentially solve the problem of flows and thus put the debate to rest; at least for some time. Alternatively, should the RBI manage to stabilize the rupee at some level, it may get FII interest back into the country and automatically put to rest the funding debate. Even though the potential disruption from point 2 above can be huge, our bias is to expect that this fear will not materialize. Either policy efforts or market forces or both should eventually lead to some currency stability (although at what level remains open for debate at this point). Hence, we continue to hold on to our front end rate positions. On the issue of point 1 above, there is a chance that market interest rate expectations may take time to settle. In the meanwhile, market will have to contend with weekly supply pressures on government bonds. For these reasons, we may add back government bonds (or the long end of corporate curve) more slowly waiting either for better pricing of risk premiums or some change back in market‟s forward rate expectations.
The recommendation to investors remains exactly the same. It is prudent to allocate 50% of new allocations to short and medium term funds, and the balance into dynamic and income funds. The rationale for this has been discussed before (refer “Recent market developments and investor takeaways”, dated 11th June for details). We continue to run dynamic and income funds actively in line with our evolving assessment of the macro-economic environment. At this juncture these funds are running conservative maturities and higher cash levels. We will look to increase maturities, based on triggers mentioned above.
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