As far as global monetary policy backdrop is concerned, the current year is different from the last in some obvious ways. The Fed moving first has proven not to be a barrier for other developed market central banks to start to cut policy rates, while policy normalization in Japan hasn’t caused large funds flow dislocations as was feared as a tail risk. Nevertheless, the Fed remains the dominant central bank in the global policy setting and it is thus important to continue to spill the requisite amount of ink in discussing US monetary policy dynamics. We do so below:
Distance To Target For Monetary Policy
The Fed has a dual mandate of inflation and employment, with the latter proxied with economic growth. The most notable aspect of change in backdrop for US monetary policy this year versus last is this: last year the distance to target for inflation was very large for the Fed, thereby making inflation the dominant variable in its reaction function. Of course, there was no tradeoff as such since employment and growth were robust too. However, the sensitivity to any turn to policy was much more with respect to inflation rather than some variation in growth. We saw this in action with the famous Fed ‘pivot’ in December. This was done on the back of inflation momentum fading in the run up to December even as growth remained strong, and in fact stronger than many had expected. As we know, this had to be reversed as subsequent inflation momentum turned up again.
More lately, however, it is getting clearer that after an uncomfortable first quarter, inflation momentum is falling again. There is also more and more evidence now that the economy may be slowing, led by consumers in the economically more susceptible percentiles of the population. For this segment, the ‘excess’ savings buffers from large fiscal transfers earlier may have run out, participation in the asset market boom is limited if any, and interest rates are an expense item. Thus, in the current context, the Fed’s reaction function has turned back to responding more symmetrically to both parts of its mandate. This is an important change from last year, as tolerance to any slowdown in growth (any unexpected weakening in the labor market as per the Fed chair) may be far lesser than what it would have been last year. From a market standpoint, Fed rate expectations which have always been susceptible to turn on a dime, are even more prone to do so given the current context as described here. Thus, it is probably logical to keep the dot plots and such things at the back of one’s mind, without getting overly obsessed by them.
Long Term Neutral Policy Rate
Another current point of debate, is whether and by how much the long term neutral Fed funds rate has moved up. Most people agree that it has, the discussion is really on by how much. The most obvious reason to expect that long term neutral policy rate has moved up is that there appears to now be a permanent reset in US fiscal trajectory. The table below shows the long term projection for US federal government fiscal deficit. The two notable observations here: 1> The new fiscal regime is here to stay 2> The medium term projections have become markedly worse from a previous forecast from February 2024, likely incorporating some global spending commitments.
A policy setting dominated by fiscal dynamics will obviously argue for higher long term neutral rates even as the eventual ‘out’ from this dynamic is to implicitly accept higher average inflation and a weaker currency.
The more interesting debate is the quantum of reset in long term neutral policy rates. Establishing this is mostly an academic exercise and one we are ill-equipped to do from the standpoint of requisite expertise. Our focus here is instead on the market debate. As per the dot plots from the June FOMC meeting, the long term Fed funds rate is projected at 2.8%. Though this is up from 2.6% in its March projection, it is still much lower than market projection of the same. A proxy for market projection, as we understand it, is the 5 year swap rate 5 years from now. This currently stands at approximately 3.6%. Thus, the argument goes, there is a substantial catch up pending for the Fed on this item. Also, it substantially limits the scope for long term bond yields to fall meaningfully. Finally, if long term neutral rates are indeed as indicated by market pricing, then current policy rates, though restrictive, aren’t so much as is ordinarily thought of merely from the amount of rate hikes undertaken in this cycle.
We would make the following observations in this regard: As mentioned above, basis US fiscal dynamics, there is concrete reason to believe that the level of long term policy rates has indeed moved up. However, we would make the same observation here as we made above with respect to near term expectations from Fed policy: things, even what we consider long term things, tend to move around relatively quickly. Thus, it is probably too soon to be too deterministic about where the debate on long term neutral rates will eventually settle. Even the Fed’s view on this keeps evolving as is seen in the change in FOMC projection just between March and now. Similarly, as is shown below in the medium chart of 5 year swap rate 5 year forward, market expectation of the long term also keeps jumping around basis what it is experiencing today.
As can be seen, this rate has moved around a bit too much over short periods of time to glean long term signals from it. Suffice to say that if near term weakness in economic data continues, it is likely that this rate falls as well and the eventual meeting point is probably somewhere between what the Fed and the market expects currently. This will still leave a lot of room for US long term bond yields to fall from where they are currently.
A similar debate is ongoing in India as well, on what the appropriate long term neutral real policy rate is likely to be. Some of the external MPC members have suggested it is 1 – 1.5%. RBI’s views on this is not fully known. While there is no market traded expectation for this in India, the general observations above should hold here as well with one difference: unlike the US, India hasn’t had any reset higher in its fiscal trajectory. If anything, we have gained greater credibility on sustained compression. This factor should be kept in mind when evaluating relative real long term neutral rates as this debate progresses. At any rate, we expect this to be a shallow rate cut cycle for India of not more than 50 – 75 bps largely for the same reason but drawn intuitively: that India’s current repo rate setting may not be very much higher than long term neutral.
India Market Observations
There are two specific points we dwell on with respect to our market:
1. The relentless pressure on front end rates owing to continued liability side pressure with banks and other lenders: If real deposit rates are reasonable (they are) and not incentivizing any exaggerated rise in currency in circulation (they aren’t), then deposit growth rate should be directly impacted by pace of reserve money growth. As we have discussed before, in our reading RBI has been wanting more transmission of its accumulated tightening with the ultimate end objective of slowing credit growth, especially in certain segments. The incremental news on both transmission and credit growth momentum seems positive from this standpoint. Eventually as RBI turns neutral and then starts leaning more dovish overtime, it will probably be accompanied by a pick- up in pace of reserve money creation thereby alleviating some of the deposit pressure as well. While the guidance is that stance is related to current propensity on policy rates and has nothing to do with liquidity, in practice the one is related to the other since they impact financial conditions cumulatively which in turn impact inflation – growth dynamics.
2. The mildly bullish view-point on rates versus the more aggressively constructive one: As we approach the likely turn in the cycle, and alongside the step up in bond inflows on index inclusion, almost everyone is bullish bonds today. The debate really is on the extent of bullishness. The more moderate bullish view rests on the following arguments; 1> Limited room for rate cuts 2> A relatively flat yield curve thereby providing little incentive to be very long on duration. 3> US rates likely to be relatively higher for longer thereby putting a floor on India rates as well. On our part, we are in the more ‘aggressively constructive’ camp, deeming this to be a structural market for India fixed income. We have delved into the reasons why multiple times over the past 6 months. A summary is provided in the note here (https://bandhanmutual.com/article/16931 ). To clarify further, our view accounts for each of the three ‘objections’ referred to over here (this is sincerely put here as a clarification and not owing to any lack of respect for the counterpoint): 1> Our view also is of limited rate cuts. However, the structural story can be visualized more directly as a very favorable demand versus supply equation for bonds, specifically government bonds. Thus, the scope of fall in bond yields is far more than that in the repo rate. 2> If our structural view is correct, then one should almost expect a flat yield curve. This can be visualized as follows: if more and more investors start to believe that a 10 year bond 10 years from now will be at a substantially lower yield than the current 10 year yield, then they should be more than willing to buy a 20 year today at the same or even a lower yield than the 10 year. Put another way, rather than demanding more term premium for investing longer, one is wanting to neutralize future reinvestment risks by choosing to invest for longer even at zero (or maybe even negative) additional term spread. 3> US fiscal dominance will likely eventually lead to implicit tolerance for higher inflation and weaker currency, in our view. As we have observed before, there is a de-premiumization of US dollar assets already underway, most obviously reflected in narrowing yield differentials which are no longer an impediment to capital flows. Further, geopolitics is already driving sporadic de-dollarization. Combined these trends argue for a longer term backdrop where investors will continue to flock to well managed large macro stories around the world like India. Overtime it should reflect in further narrowing of yield spreads between India and the US.
Disclaimer:
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of Bandhan Mutual Fund (formerly known as IDFC Mutual Fund). The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the security, if any, may or may not continue to form part of the scheme’s portfolio in future. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. The decision of the Investment Manager may not always be profitable; as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement/document as may be required from time to time. Neither Bandhan Mutual Fund (formerly known as IDFC Mutual Fund)/ Bandhan Mutual Fund Trustee Limited (formerly IDFC AMC Trustee Company Limited) / Bandhan AMC Limited (formerly IDFC Asset Management Company Limited), its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information. Past performance may or may not be sustained in future.
