Backdrop
The US exceptionalism narrative continues to go from strength to strength with Trump related expectations converging with continued strong economic data. This has led to a sustained rise in bond yields and strength in the US dollar. Indeed US 10 year yields are more than a 100 bps up from the first Fed rate cut in September, a truly remarkable turn of events! At the same time, incremental Fed easing expectations have been pared back substantially, with market expecting just about one rate cut over the current year. However, in a reflection of how disparate the world is, expectations for ECB are still for much more meaningful easing during the year.
The rise and rise of the dollar and yields is obviously exerting renewed pressure on emerging markets (EMs). In varying degrees, depending upon extent of integration on trade and capital flows, this is restraining the extent of policy space available in these economies. To be fair, these traverse a spectrum. The more dependent EMs are now seeing domestic macro-policy virtually hostage to the US tide. On the other side EMs like India have much lesser dependencies but yet are obviously facing shrinking degrees of freedom when conducting domestic policy. This is particularly inconvenient for us at this juncture, given the visible cyclical slowdown in growth that requires renewed policy attention. We turn below to a more detailed evaluation of the Indian context.
Constraint Optimization
We have discussed before the post Covid framework for macro policy (https://bandhanmutual.com/article/19734). This has entailed ensuring continued sustained growth expansion in order to be able to recoup the cumulative gap in output since the pandemic but to be able to do so with the limited degrees of freedom available from continued US fiscal exceptionalism. The asks and boundaries entailed under this framework have grown starker over the past few weeks. On the one hand there is clear evidence now of a cyclical slowdown, thereby requiring a stepping up of support from policy. On the other, the US exceptionalism trade has grown stronger, thereby further curtailing degrees of freedom for local policy. It is in this context that we turn next to a macro policy discussion.
From a monetary policy perspective, our view is that the recent discussion on the merits of food inflation coming in the way of rate cuts has at best a limited degree of relevance. At 6.50% the repo rate is not particularly restrictive, especially given the global context. For the same reason, it offers limited room for easing. Hence, our view has been of a shallow rate cut cycle of 75 bps unless there is a hard landing on global growth which at the moment is looking somewhat unlikely. Also for that reason, given degrees of freedom on policy have shrunk further on the margin, a repo rate cut can easily be deferred for now.
Rather, the notable point has been the rapid decline in core liquidity over a relative short period of time which has amplified the squeeze in the banking system when credit growth was already slowing down. This has largely been on the back of forex interventions by RBI in defense of the exchange rate. To that extent, it doesn’t represent a one-off, sudden episode that couldn’t have been compensated for via changes to discretionary liquidity management tools. Indeed, to our understanding, the RBI has discouraged market’s speculation on its liquidity stance, implicitly assuring almost automatic adequate liquidity provisioning while using its policy stance to communicate probability of change in the repo rate basis evolving assessment of growth-inflation dynamic.
However, the liquidity developments over the past few months have led the market to rethink this implicit ‘contract’, thereby now levying a higher burden of proof on RBI to reassure participants that nothing significant has changed on this front. The argument that a tighter rupee liquidity environment is needed as part of the exchange rate defense toolkit doesn’t pass the smell test on cost vs benefit for us. Also, to be clear, the CRR cut administered in December merely part compensates for the liquidity drain and will not prevent core system liquidity falling to below zero before March end absent further significant measures. It is here that abundant scope exists for rectification, although again the flexibility to do so would have been greater had these measures been administered in smaller doses over a period of time over the past few months.
Fiscal policy will have its own constraint optimization to do. Slowing growth will require some measures even as two successive years of below 10% nominal GDP growth rate will reduce cushion on receipts adjusted for one-off receipts. At the same time, it is very important to sustain the fiscal credibility built over the past few years. This encompasses a credible path of consolidation, greater budget transparency, and shift towards more productive spending.
Conclusions
The above discussion leads us to some conclusions on what we think macro-policy will likely entail in the near future to optimize on constraints. Indeed, first signs of some move in the direction may already be in play as well.
1. RBI will likely smoothen policy intervention over a period of time with respect to the quantum of forex defense used and its consequent impact on rupee liquidity. This will be more consistent with the idea that while offsets may be forthcoming on US exceptionalism, the ‘when’ of it is quite uncertain and policy cannot afford to make this timing call.
2. However, the fact remains that the domestic liquidity situation currently reflects a more pointed approach taken earlier and needs urgent rectification. This will need addressing quickly preferably via permanent infusion measures and especially as continued dollar strength and seasonal rise in currency in circulation are increasingly making this a time-is-of-the-essence issue.
3. A repo rate cut can easily be deferred for when degrees of freedom are better. So long as reasonable liquidity comes back and is assured on an ongoing basis, we don’t think the repo rate will come in the way, at least for the time being.
4. Fiscal spending may modestly recalibrate on the margin in support of shoring up domestic consumption. However, we expect the broad guardrails to be intact and the government to follow through with the forward looking fiscal framework given earlier.
Portfolio Strategy
In a broadly ‘unforgiving’ global environment, portfolio strategy should favor two anchors for selection, in our view: 1> Demand – supply narrative is sound with adequate valuation cushion 2> If demand-supply narrative is not as sound then valuation cushion should adequately reflect the fact. We think the first criterion is met on duration via government bonds and the second on carry on front end of the corporate bond curve, currently most notably represented by 1 year bank CDs. Longer up the corporate bond curve is inverted to the short end and the spreads here are thin with respect to underlying government bonds. These, then, don’t represent adequate risk-reward given the context. Credit risk strategies should similarly be deployed selectively where the focus shouldn’t be on absolute yield on offer but rather on the spread over corresponding AAA maturity adjusted for the respective narrative on the two. To be clear it is not meant here that the proposed strategies don’t come with volatility, but rather that they offer the best portfolio construction in our view over requisite investment horizons and accounting for near term appetite for mark to market volatility.
Source: RBI and Bandhan internal research
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