1. Global policy rate peak: The December Fed pivot marked the official peak to the global rate cycle. While the Fed and the markets are unanimous on easing for the current year, the discussion is now more on quantum of cuts with the market pricing roughly twice as many rate cuts as the median of FOMC members’ expectation. Nevertheless, the underlying point is simple: as inflation comes off, nominal policy rates have to adjust lower so as to keep real rates unchanged. Further, market discussion has commenced on the Fed having to lay out plans to reduce the pace of quantitative tightening soon. In Europe, the ECB has been less yielding on commentary but given that economic data there is weaker and the possibility of fiscal tightening more meaningful, markets have nevertheless priced in generous easing for 2024. Meanwhile, while expectations remain for the Bank of Japan to normalize policy, market impatience around the same has now been pushed back. The change in backdrop for developed market (DM) monetary policy and bond yields has in turn eased some pressure off other central banks around the world.
2. RBI Policy: The view remains that RBI’s scope of rate cuts will be considerably more limited as compared with the US or Europe since cycle peak on rates is also closer to long term neural for India as compared with these economies. Nevertheless, we do expect 50 – 75 bps of cuts to come through for India over the financial year ahead. Turning more to the micros, it may be recalled that over the past few months RBI had started to display active concern about the quantum of excess liquidity in the system. This constituted an added layer to the liquidity framework hitherto in operation: target weighted overnight rate around repo rate using the variable rate operation tools. This change also led to the overnight rate effectively at the MSF rate rather than the repo rate for an extended period of time; so much so that the money market curve started to price off overnight rate at 6.75%. One can only speculate what led to this change in RBI. One probable reason could be repeated food shocks alongside strong underlying economic growth and a hawkish global environment during that period. This may have justifiably led the central bank to up its guard. Whatever the reasons, there is optimism that this last leg of effective tightening is now unwinding. Thus RBI has turned quite proactive recently with supplying liquidity to the market via the variable repo rate. Again one can speculate that this change may have been brought about with local inflation dynamics stabilizing (more on this below) and the global rate environment easing. We expect MPC to change policy stance by April and actual rate cuts to happen probably over second half of the calendar year.
3. Inflation: India’s inflation has had two underpinnings for most of the past few months: 1> very well behaved core inflation dynamics (with caveat of some data issues flagged here most notably in housing). 2> frequent food shocks imparting volatility to headline inflation. That said the well behaved core dynamics has finally yielded a core inflation reading of sub 4% in the latest reading for December (first time since March 2020). Equally notably, government interventions to manage supply side on food to the extent possible have been extremely proactive thereby compressing duration and intensity of the food price shocks. As a result, as of date not only is the near inflation trajectory set to substantially undershoot RBI’s latest forecasts, but the calendar year ahead may see very few readings above 5% on headline inflation. That said, a large caveat is in order: given progressively worsening climate vagaries one should almost expect periodic food price escalations even as one doesn’t necessarily model for them in forecasts. Even so, inflation dynamics and government’s ongoing supply side response are very reassuring. The rate cut discussion in India will also likely start soon enough on the same real rate argument that is currently already being made in the Western world. Two of the external members of the monetary policy committee have already turned somewhat more vocal on this point.
4. Current account deficit: We have highlighted this point before as also constituting one of the key reasons for us turning more constructive on long duration. This continues with forecasts for FY25 also quite benign on this front. On the capital flow side, the slowdown in net foreign direct investment (FDI) has been a bother but some optimism is beginning to sprout that we may soon turn a corner here. On that point, and although it is just one data point, October has seen a substantial jump in net FDI inflow. If a turn around here is indeed due then more comfort may be forthcoming at the level of basic balance as well (current account plus the most stable source of its financing, net FDI). At any rate, the overall balance of payment looks quite comfortable especially with the market looking forward to additional capital flows on account of the bond index inclusion.
5. Fiscal Deficit: This is often cited as the weakest aspect of India’s macros. While at headline level the fiscal deficit is quite large, certain important caveats are in order. First, even though center’s fiscal deficit still looks high, total public sector deficit is now very close to what it was in FY20. This is because the bulk of the post pandemic response was shouldered by the center whereas reliance on resources of public sector enterprises has actually shrunk during this period. Thus only looking at central fiscal deficit exaggerates the magnitude of expansion. Second, even with total public sector deficit at around 10% of GDP, India is still seeing an economy wide current account deficit (aggregate investments minus savings) at a very benign level of around 1.5%. This means that for the most part the public sector is channelling excess savings of the private sector and there is no widespread crowding out or overheating that we are seeing. This is also supported by evidence from the bond market: long term rates are stable with firm demand from investors. Additionally, we have seen a notable jump in gross tax to GDP ratio this year (higher than the pre-pandemic period) which if sustained can lend additional flexibility to the government in consolidating its deficit in the years ahead. At any rate, we expect a large down-payment on this endeavour for FY25 with the vote on account likely to show a 50 – 70 bps consolidation from FY24.
6. Bond Flows: An often cited source of bullishness for India bonds is the upcoming inclusion in a large global bond index (and possibly another smaller one). Indeed the market is already seeing increased traction from foreign portfolio investors (FPIs). We share the optimism and, indeed, are at risk of being more optimistic than most on this count. One, unlike the dominant market view on this we expect RBI to neutralize only a small part (if at all) of this flow by selling bonds to the market. This is somewhat to do with evolution of core liquidity, but mostly because we think by the time major flows come RBI may have shifted its policy stance. This may entail reverting to anchoring overnight rate to repo using variable rate operations instead of focusing also on the amount of excess liquidity in the system. Indeed it is to be noted that most of the rate hike program in the current cycle has been conducted in an environment of heavily surplus liquidity. Thus most of the inflow will likely constitute net incremental demand for Indian bonds, in our view. Two, and this is somewhat more ‘blue sky’, the added attention to Indian bonds courtesy the index inclusion is happening at a time of adverse US fiscal dynamics and a possible long cycle top in the US dollar. On the other hand, India stands out as a growing economy with healthy macro-economic dynamics. This may eventually lead to larger bond allocations overtime than just the mathematical calculation related to index inclusion may suggest.
7. Valuations: Although as discussed above RBI’s rate cuts are likely to be modest, what is also true is that India’s yield curve is decently positive sloping at the top of the cycle. Thus a strong performance from bonds over the next few years may not necessarily require a very aggressive rate cut cycle, especially if the current macro-economic dynamics continue and some of the hoped for probable outcomes discussed above fall in place. This is not to say that there aren’t any risk factors to consider. However, the balance of factors as analyzed above are overwhelming in favour of keeping a constructive stance on quality bonds, in our view.
Conclusion and Strategy Update
We have been highlighting for some time that investor behavior needs to now shift from maximizing carry and minimizing duration that has been followed over the past couple of years, to actively elongating duration via quality bonds in order to plug potential future reinvestment risks. This is also a period where duration and relative spread movement should be given more weight than the passive selection of the highest yield on portfolio. Corporate bond spreads have been widening over the past few months in line with our view and these may remain wider at least for the current quarter given the pressures of busy season credit demand and relatively tight liquidity. We are using this period to slowly increase corporate bond exposures in certain funds that have been very overweight government bonds so far and where such rebalancing can be done without reducing overall portfolio maturity. In our actively managed bond and gilt funds, our most overweight exposure (> 50% of portfolio) is now in the 30 year government bond even as we continue to hold significant exposures to the 14 year government bond as well.
Source: Bandhan MF Research
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