I Don't Wanna Be You Anymore : A Macro And Bond Update

The past year has been a rollercoaster of sorts for global markets. The two defining features of the period have been: One the commodity shock emanating from the Russia – Ukraine war. Two, the continuous pursuit of establishing what the terminal policy rates are likely to be in major economies; most chiefly the US. The first of these has unwound substantially and, outside of some agricultural commodities, prices on many other major ones are actually lower than they were a year ago. This has alleviated a substantial pain especially for major commodity importing emerging markets (EMs) like India.

The second, however, has turned out to be far trickier with multiple false dawns along the way only to be followed up by a rude awakening. August – October of last year was one such period where stronger inflation data led to a substantial leg up in terminal rate expectations for the Fed. This was followed up with a period of relative calm which then began giving way to optimism around the start of the new year. This was brought about by softening data that in turn gave grounds for a hope that a ‘soft landing’ may indeed be possible. This hope received an official stamp of approval from none other than the Fed Chair himself who, in the press conference post the last Fed meet, observed that the disinflation process has started. Even more, despite being given more than one chance to push back against the recent loosening of financial conditions led by market’s new found optimism, he refused to do so. This was justifiably perceived as a green signal by markets to further lean into the soft landing trade.

The next rude awakening was led by almost an outlier strong spate of economic data, and just when the soft landing narrative had turned mainstream. At the time of writing, this has led to almost another 100 bps hike in Fed funds terminal rate pricing, as can be seen in the following chart.


There are multiple reasons put forward for this stronger data including weather and seasonality. More noteworthy, however, is the fact that financial conditions had stopped tightening some time back and in fact had loosened somewhat lately. This is shown in the chart below.


Also, fiscal policy has worked somewhat against monetary policy especially in Europe and to some extent in US. That is to say consolidation from the post pandemic stimulus hasn’t been as rapid at general government level and protecting citizens against the commodity shock has been at the cost of some fiscal expansion against earlier run-rate, rather than merely rerouting spending from elsewhere while keeping the consolidation path unchanged. This has led to better consumer resilience than was earlier believed.

An important dynamic of this DM tightening so far is that credit spreads on high yield have remained remarkably well contained. As can be seen in the chart below, they seem to be even off their recent peaks of mid-last year. This is also a contributor to the relatively loose financial conditions. The narrative is one of cleaner balance sheets with most post pandemic incremental debt residing with the state rather than with companies and consumers. However, this also means that companies will have to continue to keep a lid on their leverage in order to ensure that their credit ratings remain intact. Slippages here will probably have amplified effects given a tighter refinancing environment. This also has to be looked at in context of rising business uncertainties especially towards second half of the year.


Not All Bad Though

There are some noteworthy aspects of this latest bout higher in terminal rate expectations that nevertheless hold some grounds for optimism. To be clear this is optimism with respect to finding some stability for sovereign rates but comes with somewhat more pessimism as far as the prognosis for global growth is concerned. The first point of note is that even with this remarkable reset in peak rate expectations, the dominance of the US dollar that was in place for most of last year up to September seems to be fading.


The chart above shows US 2 year treasury yield (used here as average policy rates in this cycle) versus the dollar index. As can be seen, while the 2 year yield has made fresh highs, the dollar index is well off its peak.

This seems partly because other major developed markets (DMs) rate expectations have risen meaningfully, most notably in Europe. However this is also because the higher the cycle peak goes from what is perceived as long term neutral, the more markets perceive as damage from rates and build in more rate cuts ahead. This is shown below. Thus while peak Fed rate expectation has exceeded 5.50%, market has built in almost 200 bps of rate cuts now over 2024 and 2025. Also notably the quantum of rate cuts built has risen with a rise in peak rate expectation.


Indian Dynamics

The biggest macro-economic variable of note generally speaking for an EM is its external account. This is because we don’t print a reserve currency of the world and hence the ability to finance ourselves is ultimately the biggest potential challenge for macro-economic stability. Within this it is the current account which gives a true picture of external sustainability. This denotes the gap between savings and investments. A wider gap here denotes fundamental unsustainability or an ‘overheating’ economy. Capital flows finance this deficit but these follow global cycles more closely. Thus the overall balance of payment may jump around basis the state of global risk appetite at that point in time in the cycle. However so long as the central bank is sensible in building reserves when capital flows are strong and uses these judiciously when the tide turns, capital account volatility can be broadly managed in a fundamentally sound nation like India.

Last year, owing to the commodity shock and possibly the pent up reopening related drawdown of savings, the current account faced considerable pressure. Even more concerning was the fact that this was happening during the one way strength of the US dollar. This combination had started the argument for using interest rates as a defence for the external sector. To be fair, the hikes being talked about were nothing of the magnitude done in 2013. However, for a while, the parallels drawn were beginning to sound alarming. Our view then was somewhat different. We were tracking the cumulative fiscal and monetary stimulus administered in India since the pandemic and the relative speed of reversal in monetary policy accommodation. We had concluded that India was not likely to be experiencing a demand overheating problem and that the current account pressure was likely to stabilise as the commodity shock and the ‘pent up’ elements smoothened out. This line of thought drew a distinction between rate hikes still needed but not going overboard which, in our view, the interest rate defence perspective would have entailed.

In the event, the current account dynamics seem to have turned for the better sooner and by a larger magnitude than what even we had anticipated. Even adjusting for some of the recent data that seems a bit too flattering, apart from the commodity shock unwinding what has surprised is the traction on the services trade surplus. As a result, FY 23 current account deficit forecasts have moved from around 3.5% of GDP earlier to almost a full percentage point lower now. Alongside, and as discussed above, while DM rates remain a matter of concern, the phase of dollar dominance seems to have stabilised. As the chart below shows, the rupee has been relatively stable since September and our forex reserves are well off the lows that they had touched then.



Our better current account dynamics alongside reducing cycle dominance from the dollar imply that we can very well now afford to look inward at our own macro-economic dynamics much more when deciding upon incremental policy tightening. This is especially so given the cumulative tightening already undertaken which, in context of a rapidly shrinking banking system liquidity, is still feeding into bank lending rates and end aggregate demand. As the chart below shows, system liquidity is heading towards neutral after more than 3 years.



Apart from all that has been discussed above, a notable aspect of the current global rate tightening cycle is the speed of it. Specifically, there is little precedence from recent history of this magnitude of DM tightening over such a short span of time. As is well known, monetary policy acts with a substantial lag. Thus concurrent data probably is an even poorer indicator of the future than is usually the case, since the amount of pipeline tightening yet to hit economic activity is much more than is usually the case in a normal tightening cycle. This is true for India as well, although to a lesser degree. Thus even in India there has been close to a 400 bps rise in the 1 year treasury bill rate as an example, from its (admittedly untenable) low hit just over a year back. Tightening of this magnitude is bound to affect economic activity, especially as we didn’t see anywhere close to the kind of fiscal and monetary expansion that DMs did.

We had earlier assessed the February rate hike to be the last for India. However, a marked overshoot in the January CPI print alongside escalating weather threats on agricultural production mean that a last insurance hike is now on the table for the April policy thereby setting a 6.75% terminal repo rate for this cycle. This would mean that the policy rate differential between India and US will likely be just over 100 bps at the respective cycle peaks. As discussed before, we expect the differential to open up again when the rate cut cycle commences, possibly starting 2024. The Fed will have peaked much higher than long term neutral and correspondingly will have much more room than RBI on the way down. Markets seem to be pricing as much as well which seems getting reflected in longer tenor US yields as shown above.

Bond markets have more than fully priced in this final rate hike over the past few weeks. This doesn’t mean that incremental volatility won’t be there, but just that volatility is now very much in a digestible range. Reflecting incremental hike expectation and a rapidly tightening liquidity environment, alongside good long duration demand towards year end, the yield curve has virtually entirely flattened. Over the course of the year ahead, we expect two things to happen: One the yield curve should incrementally steepen somewhat. While the near trigger for this is dependent upon the distribution of the government borrowing calendar, we are more confident of it happening towards the latter part of the year when markets are likely to start building in some modest policy easing. Two, credit spreads should begin to open up, especially for lower rated issuers reflecting a tighter refinancing environment. Given the above, our preferred overweight remains 3 – 6 years maturing government bonds wherever allowed by scheme mandates. A related point needs making: while elevated money market rates make utmost sense for short term investors of up to 1 year horizons, longer term investors are probably ignoring future re-investment risks by tying themselves too much into 1 year deposits. The 3 – 6 year segment may be much better placed for such investors, in our view.

It is our strong view that this is the period to build quality fixed income allocation. The global economic narrative will likely turn more uncertain (ex-China) as the cumulative global tightening shows. Local bond market volatility is now within manageable ranges. Bond yields even of best quality are now beating expected inflation on almost any forward looking timeframe. And finally, spreads on lower rated credits are low enough that one need not bother there. These should constitute more than adequate reasons for now going overweight quality fixed income, not just for traditional fixed income investors but also in a multi-asset allocation framework.



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