Although we’d just done a detailed macro and strategy note recently, much has been happening in the world to merit an update. Stress at US regional banks followed up by worries around a large European one have suddenly brought financial contagion prospects front and centre with investors and regulators. This has had dramatic effects on the expected path of monetary tightening as well. We’d done a series of charts in our previous note, and a good way to start this commentary is to compare these with where they stand today, just about a week later.
As can be seen above, the expected Fed funds rate as at Dec 23 has fallen by a staggering 170 bps plus over the past week or so.
We’ve changed the financial conditions index from the Chicago Fed one used in the earlier note to the Bloomberg one since the latter is updated more frequently. As can be seen below there has been a notable tightening recently.
One important reason this is happening is that high yield spreads have finally started to move, as shown below
The dramatic fall in US 2 year yield over this short a span reflects the equally notable changes in rate expectations. This size of a move over such a short span of time has little precedence from the past few decades.
Peak cycle rate expectation has come off by about 75 bps to 4.90% and market has built in 100 plus bps rate cut over 2023 itself. Correspondingly, cut expectation over 2024 and 2025 have been reduced by around 125 bps to ‘only’ around 65 bps currently. This is shown in the chart below.
Finally, and a chart we hadn’t referred to before, the 30 year to 2 year had inverted significantly over the past few weeks to more than 100 bps. This was signalling high probability of some sort of ‘breakage’. Having done its job of signalling and with those signals largely having materialised, this inversion has now corrected significantly as policy rate expectation itself has been significantly brought down. This is shown below.
Putting It All Together
The current global monetary tightening cycle is most notable for the magnitude of tightening done over just about one year. The probability of something breaking logically goes up when something like this is happening. The problem always is you don’t really know what will, and versus what broke in the last cycle it is very unlikely that the same thing does again. In the current case consumers, corporates, and large banks have looked relatively healthy. The new tech and housing sectors are more rate sensitive and have been showing stress. But the focus so far has been on economic channels of transmission rather than financial market ones. The current scenario brings focus back on to the latter. Although the jumping around of global markets over the past few days has been large enough so that the charts presented above may soon change shape yet again, what is relatively surer is that financial stability risks will hereon be more on the minds of central banks than the case has been so far in this tightening cycle.
A notable aspect of this scenario is the potential dilemma it may pose for developed market central banks. Most previous financial market episodes were in a low inflation environment. Thus there wasn’t any trade-off to consider when responding, and hence central banks could afford to ride to the rescue in the most spectacular fashions imaginable. In the current case, however, responses need to keep in mind the fact that inflation is still roughly 3x of targets. That said, two things need to be considered: One, it is still unclear how deep and long the current stress is for. If it proves to be not as deep and long lasting (no view here, just doing the scenario analysis) then the period of conflict for central banks may also correspondingly subside. Two, the channel of transmission is via tightening of financial conditions. Even if rate hikes stop, wider credit spreads and lower asset prices may continue the process of financial conditions tightening. This will in turn keep working to diminish aggregate demand and hence curtail inflationary pressures. If anything, this kind of financial tightening tends to be unpredictable and the risk is of too much incremental tightening over a short period of time.
Economic and market agents tend to modify behaviour as they become more risk averse thereby making the tightening more sustained and broad-based. Thus some amount of central bank push back to this in terms of liquidity measures and stoppage / reduction of incremental planned rate hikes may not necessarily create inflation risks. The bigger point, and one that risk assets will have to keep in mind for some time going forward, is whether the riding to the rescue in the face of economic /financial conditions headwind can be anything like it used to be before, given that the scars from the current high inflation episode will likely sustain for some time. In summary, it is fair to expect that the current contagion lingers at least via tighter lending standards (US bank loan officers were already tightening standards) for both banks and bond markets. This itself poses an additional growth headwind and, ceteris paribus, reduces the need for the Fed to keep hiking rates.
The Indian Context
India’s balance sheet issues that at one point had stretched across many of the large lenders and borrowers are broadly behind us (company specific stress is a micro and not a macro matter). The monetary and fiscal stimulus post Covid have been responsible and monetary conditions have been tightened proactively over the past year. Our current account deficit has compressed significantly, thereby curtailing external risks. Commodity prices (outside of agriculture) have come off meaningfully, thereby further curbing both current account and inflation risks. Finally, and even though the current bout of risk aversion may provide some tailwind to the dollar, the long phase of global dollar dominance of last year seems to be largely over. For all these reasons, India’s macro-economic strength will likely hold us in good stead.
The variables to monitor for us are therefore much more mundane, but nevertheless may hold some implications from a bond investing standpoint. One such is the centre’s fiscal deficit which has been slow to compress even with the advantage of a very large nominal GDP growth buffer in the current financial year. This has been for a good reason, but still poses a challenge for meaningful compression in the year ahead. This is because nominal growth for the year ahead will likely undershoot budget assumptions. If recent global events pose a sustained risk of financial tightening and hence to global growth, then our nominal growth correspondingly risks a further slowdown. Thus it is quite possible that the receipts side faces some challenges as we go deeper into the new financial year. Whereas, slowing growth will argue against compressing expenditures to neutralise the revenue slowdown. While still early to be conclusive on this yet, we expect the FY24 fiscal deficit target to face some threat. Long duration bonds may hence need to account for this at some point.
While we still attribute some probability for a final rate hike from RBI, recent events may very well weigh against this. Enough has been done as it is and bank lending rates will anyway continue moving higher with diminishing liquidity. The rising global risks on the margin and the potential headwind to global growth hence faced should ordinarily be enough to take the final rate hike off the table. Also while weather disruptions continue to pose risks to agricultural commodities, other ones including oil have come off sharply reflecting growth fears. That said, investors should be largely agnostic even if there’s an ‘insurance’ hike coming given that markets will likely focus much more on the path ahead.
Takeaways
With the commodity shock seemingly behind us, the phase of dollar dominance largely stable now, India’s current account deficit more manageable, and the cumulative impact of rate tightening still to play out fully, we have strongly suggested going overweight quality fixed income. Notably, we have said so not just for traditional fixed income investors but also in a multi-asset allocation framework. The events of the past few days and the possibilities that they may pose as analysed above, if anything, argue for some hurrying up in achieving this allocation. The best risk-reward continues in the 3 – 6 year segment, in our view. If rate hike expectations stabilise / subside then the curve steepening may start sooner than we earlier anticipated. Finally, we expect credit spreads to continue to widen reflecting a tighter refinancing environment.
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