By Suyash Choudhary
The last three months or so have been very notable for global macro. The US Fed has executed a spectacular pivot, not just jettisoning its previous transitory characterization of inflation but now treating inflation as the dominant threat to the continuation of economic expansion.
Reflecting this, and backed by continued momentum in data, the market now expects the Fed to raise rates up to seven times this year and start reducing its balance sheet sometime over the next few months. US 2-year treasury yields are up an eye-popping 100 plus basis points over the past 3 months, reflecting these developments. Some of this, although in milder degrees, is playing out in other major developed markets as well. Mercifully, however, there are counter-balances. The dollar index hasn't done much over this period of substantial re-rating on US monetary policy expectations, thereby limiting pressure on emerging markets. China's slowdown and accompanied monetary easing is an important counter-balance. Also, in general the levels of macro imbalances seem much lower this time around in many emerging markets.
The other worrisome development has been the rise and rise in global commodities. The price of oil, as a widely tracked and very important import for India, has risen some 20 per cent since the start of this calendar year; though it is a more manageable 12 - 13 per cent over the past 3 months since prices had dipped on the Omicron wave fears and then have risen since December. Still the general continued rise in commodities is worrisome especially as, alongside an underlying tighter demand - supply balance (at least in the near term), geopolitical dynamics are on a knife-edge.
All told, and especially after considering the unpleasant surprise to the Indian bond market from the gross borrowing number announced in the budget, there has been potential for things to get very sticky for bond investors. This is precisely how things were shaping up for most of January and the early part of February. The Indian 10 year government bond yield rose by something like 50 bps between mid-December to early February, a feat all the more remarkable after a dovish December RBI policy. However, the central bank has stepped up to assuage fears.
The February monetary policy review reiterated the dovish message from December, this time with added analytical support including from the forecasted path of inflation evolution (https://idfcmf.com/article/7085 ). RBI has also intervened in the management of bond supply. Together with the government, it has cancelled successive auctions thereby taking out a meaningful chunk of the current quarter's anticipated bond supply. As a result of this bond yields have cooled off substantially. Yields in our preferred overweight segment (4 - 5 years) are almost back to their December levels. The added advantage here has been another 20 bps steepening of the curve since mid-December (4 year has outperformed 10 year by 20 bps). This is directionally consistent with our overall view expressed before, though the magnitude of such changes is anyone's guess.
Putting all of the above together, we analyze the current macro / bond framework below:
Global Macro: The current state of global macro decidedly paints a hawkish picture. The US inflation data continues to broaden and has momentum, at least for now. This is translating into a feeding frenzy of Fed being behind the curve observations and consequent need for dramatic action. This in turn is getting reflected in a continued piling up on market interest rate hike expectations. Indeed, more than one mainstream forecaster now expects the Fed to start off with a 50 bps first hike. While the yield curve is flattening, this isn't alarming as of now. Thus, and irrespective of one's views on how the growth-inflation dynamic may evolve later on in the year, there is momentum to hawkishness for now and therefore too early to call a turn.
It is also true that financial conditions for the world are dictated much more by the US (which is tightening) than China (which is loosening). In fact, if the market starts to think that China's growth is stabilizing then ceteris paribus it may also start thinking of somewhat higher commodity demand in an already supply-constrained environment. Remaining on the subject, the near dynamic for oil does look reasonably tight from popular commentary, even as views diverge on what happens over the second half of the year (some think the oil market will start to get oversupplied). Added to this is a significant geo-political premium. While this may ebb and flow depending upon ongoing developments, the underlying narrative is unlikely to change in a hurry. Thus global macro will likely continue to present a hawkish picture over the next few months, marked intermittently with fresh concerns or relief.
Domestic Bond Supply: This has been a long standing concern of ours and with the borrowing number announced in the budget, this concern remains ever-present. This is not just linked to the relatively slow pace of fiscal consolidation (understandable from a macro-context but still a challenge from a bond supply absorption perspective) but also to the heavy bond maturity profile over the next few years that will mean higher gross borrowing numbers (and hence larger supply of duration to the market). Given this, the base case assumption has to be that yield ranges will gradually drift up.
To clarify, yields will get 'oversold' within these ranges (and this will define the top of the range for that time period) and will retrace from there, as is happening currently. However, so long as the demand-supply equation for bonds when looked at one calendar quarter or half year at a time remains adverse, it is hard to argue for a sustained fall in yields. If this point is agreed upon, then one has to balance 'carry' versus potential loss on duration when selecting which parts of the yield curve to inhabit. For us this has been largely 4 - 5 years so far. Longer duration bonds aren't bought for carry alone (save for really long term horizons) but also for some view on the potential mark-to-market risk there. And so long as the current demand-supply dynamics hold, it is hard to argue to quantify risk in longer duration bonds, in our view (save tactically where one plays a given trading range).
The other important point in 'respecting the ranges' is that valuations matter, especially given a hawkish global setup. Thus, if market sentiment starts getting wide-spread optimistic that is probably a good time to start to worry about valuations. Admittedly this is very difficult to call and there's a chance one gets the judgement wrong. This is even more so as curves are steep and valuations thus are generally quite attractive. The related point, and one we have dwelled upon at length in the past, is the issue of the substantial loss of carry when one chooses to get defensive. However, when the global environment is as challenging as it is today, there is value to some amount of nimbleness/active management/risk management, even while keeping the underlying framework intact. Of course, this may not apply to long term passive asset-allocators.
RBI Policy: Our view remains that this will likely be a shallow rate cycle, and that peak effective overnight rate will be lower than in the last one. This takes into account the nature of the global recovery (intense fiscal stimuli in developed economies that otherwise have much lower longer term trend growth rates), the cumulative policy response in India (much more measured), and local growth dynamics in the run up to Covid striking. Thus our long held point has been that it is bond supply rather than RBI that one has to fear. In turn this view has dictated our choice of positioning. This has been as follows:
a. Preference for 4 - 5 year maturing government bonds. The dynamics behind this have been elaborated upon above, including the related point that it is hard to assess risk in longer duration bonds.
b. Avoiding long tenor floating rate bonds and bond-swap as sustainable interest rate rise defences (although the latter can be used tactically). The long tenor floating rate bond, or bond-swap for that matter, would be very lucrative hedges if the fear was RBI policy and not bond supply. This, however, is the exact opposite scenario in our view. Thus for the long tenor floating rate bond, coupon fixings may rise painfully slowly owing to a dovish RBI while the fixed rate equivalent bond yield (approximately representing opportunity loss for that tenor of investment, even as it is understood that the floater may be bought by a different class of investors) may continue to rise on account of higher bond supply.
Bond-swaps may also suffer over time as bond yields will have a supply premium which swaps may not. This will manifest all the more clearly once the global hawkish environment turns and hence the 'paying pressure' on swaps starts to dissipate even as local bond supply concerns remain very much alive. We have dwelled on some of these dynamics around using interest rate hedges in an earlier note (https://idfcmf.com/article/6175 ) and concluded that 'bar-belling' remains the most persuasive defence in this environment.