The theme of emerging market currency depreciation on account of Fed possibly „tapering‟ QE had started last month. However, over the last few days it has reached almost panic proportions. While depreciation has been a story for most emerging markets, the rupee (along with some other high current account deficit countries) has borne a larger brunt than most. The rupee has been in a virtual free fall over the past couple of session, threatening to go towards 59 levels at the time of writing. The RBI has been largely absent in defending the currency, possibly because the sell off is part of a larger global phenomenon and the central bank is waiting for the currency to stabilize at some level. Alongside, FIIs have been pulling out from bonds. India has seen INR 15,000 crores odd of debt outflows over the past few days as exposures have been cut. As a result of these, domestic bond yields have risen 15 – 20 bps across the curve over the past few sessions. Apart from FII selling, market is fretting that the possibility of near term rate cuts from the RBI has turned quite low with this currency action.
We have been pointing out for some time that in its recent frenzy, the bond market has been under-estimating some macro-risks that first need to be clarified before an aggressive interest rate cycle can start. It is important to note that what is happening over the past few days is simply a manifestation of some of the risks that have anyway been lurking just below the surface. We had highlighted some of these in a recent note (refer “Can aggressive monetary easing create a funding problem in India?” dated 29th May). However, the tendency over the last 45 days has been to straight line extrapolate a near term confluence of benign data and expect substantially further monetary easing in the immediate few months ahead. Also very importantly, most such views have been based on traditional growth versus inflation constructs without focusing enough on the implications for the domestic funding environment if policy rates were to be cut aggressively without first addressing some of these macro-risks. This analysis is important since if RBI policy disregards these risks then there is a real possibility that market rates eventually disjoint from RBI policy rates; as has happened before in this cycle.
Given the above dilemma of balancing macro-risk factors with near term aggressive rate expectations of the market, our approach has been to focus on providing median participation while at the same time not over-extending duration; since the risks highlighted can actually hit anytime (as seems to be happening currently). Towards this end we have been increasing cash levels in our dynamic and income funds over the past few days and simultaneously moving towards more conservative average maturities. Alongside, we have also been advising clients to make 50% of new allocations to more conservative funds like MT and ST. The logic for this is as follows: Taking 10 year government bond as benchmark, yields have fallen from 9% in 2011 to 7.30% today. During this period (and especially over the last year) we have been aggressively asking investors to come to our income and dynamic funds so as to ensure maximum participation in the rate fall. These funds in turn have run aggressive maturities in order to maximize participation. Indeed, industry trends indicate that bulk of allocations since late last year have happened to this category of funds. At t his juncture, after a 170 bps fall in yields the market is debating the last 50 bps odd or so. As we have been pointing out, this 50 bps may come with substantial 2 way volatility and over a prolonged period of time (an important difference here is „one touch‟ fall in yields versus yields sustainably finding a lower level). Hence, the risk versus reward indicates that investors adopt a more medium duration strategy in this phase. This may cause them to lose some participation in periods of market frenzy (as happened in May). However, it will also plug downside risks in volatile times and help preserve returns already made over the last year. This thought will continue to define our approach.
Nothing changes in terms of market view going forward. Market is unwinding its aggressive near term rate cut expectations to some extent. However, near term inflation data will likely continue to look weak and forward interest rate cut expectations should prevent any significant sell off in yields (currency being the big question-mark, obviously). Hence, investors should not panic on this near term volatility. At the same time, investors need to decide the participation level they desire and accordingly make fund selection. To reiterate, our income and dynamic funds will aim for median participation so long as we judge macro-risks remain. If we see a clear window for participation, we may take participation levels higher as we have been doing historically. MT and ST will always be more conservative as per mandate (ST more than MT). Hence, investors who want even more conservative participation should increase allocations to these funds on new investments.
We have been pointing out for some time that in its recent frenzy, the bond market has been under-estimating some macro-risks that first need to be clarified before an aggressive interest rate cycle can start. It is important to note that what is happening over the past few days is simply a manifestation of some of the risks that have anyway been lurking just below the surface. We had highlighted some of these in a recent note (refer “Can aggressive monetary easing create a funding problem in India?” dated 29th May). However, the tendency over the last 45 days has been to straight line extrapolate a near term confluence of benign data and expect substantially further monetary easing in the immediate few months ahead. Also very importantly, most such views have been based on traditional growth versus inflation constructs without focusing enough on the implications for the domestic funding environment if policy rates were to be cut aggressively without first addressing some of these macro-risks. This analysis is important since if RBI policy disregards these risks then there is a real possibility that market rates eventually disjoint from RBI policy rates; as has happened before in this cycle.
Given the above dilemma of balancing macro-risk factors with near term aggressive rate expectations of the market, our approach has been to focus on providing median participation while at the same time not over-extending duration; since the risks highlighted can actually hit anytime (as seems to be happening currently). Towards this end we have been increasing cash levels in our dynamic and income funds over the past few days and simultaneously moving towards more conservative average maturities. Alongside, we have also been advising clients to make 50% of new allocations to more conservative funds like MT and ST. The logic for this is as follows: Taking 10 year government bond as benchmark, yields have fallen from 9% in 2011 to 7.30% today. During this period (and especially over the last year) we have been aggressively asking investors to come to our income and dynamic funds so as to ensure maximum participation in the rate fall. These funds in turn have run aggressive maturities in order to maximize participation. Indeed, industry trends indicate that bulk of allocations since late last year have happened to this category of funds. At t his juncture, after a 170 bps fall in yields the market is debating the last 50 bps odd or so. As we have been pointing out, this 50 bps may come with substantial 2 way volatility and over a prolonged period of time (an important difference here is „one touch‟ fall in yields versus yields sustainably finding a lower level). Hence, the risk versus reward indicates that investors adopt a more medium duration strategy in this phase. This may cause them to lose some participation in periods of market frenzy (as happened in May). However, it will also plug downside risks in volatile times and help preserve returns already made over the last year. This thought will continue to define our approach.
Nothing changes in terms of market view going forward. Market is unwinding its aggressive near term rate cut expectations to some extent. However, near term inflation data will likely continue to look weak and forward interest rate cut expectations should prevent any significant sell off in yields (currency being the big question-mark, obviously). Hence, investors should not panic on this near term volatility. At the same time, investors need to decide the participation level they desire and accordingly make fund selection. To reiterate, our income and dynamic funds will aim for median participation so long as we judge macro-risks remain. If we see a clear window for participation, we may take participation levels higher as we have been doing historically. MT and ST will always be more conservative as per mandate (ST more than MT). Hence, investors who want even more conservative participation should increase allocations to these funds on new investments.
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