Vijay Kumar Gaba

The weather in India these days is as diverse as the country itself. There are severe floods (usually not seen in pre monsoon period) in North East; cyclonic storms in East and South East, torrential rains in South; drought in North and scorching heat in North and West. Power supplies are challenges; wheat has ripened early; sugar cane is drier; seasonal vegetable crops have been damaged.

The US Federal Reserve in its latest policy briefing hinted that “it might begin to think” that “when it should begin to think” about the change in its policy stance of near zero interest rates. From whatever the 18 members of the US Central Bank might have uttered at the meeting of FOMC or thereafter, a broad conclusion has been drawn that the wolf might be sighted sometime in the year 2023. There are few who “fear” that wolf may surprise the markets by advancing its appearance in 2022 itself. Notwithstanding, there is a sizable number of experts who continue to believe that wolf of rate hike may not be coming in 2022 or 2023 or even 2024. Some also believe that this wolf does not exist only.

Ms. Market, on its part, has realized that there is nothing to worry for next 12months, insofar as the Federal Reserve’s monetary policy is concerned. She has therefore decided to follow the “will cross the bridge when we reach there” approach.

The younger brother ECB has decided to side with the markets. The ECB’s President Christine Lagarde recently emphasized “the policy maker has room to cut rates if needed.” It may be pertinent to note here that so far in 2021, no developed country has changed its policy rates. Amongst emerging markets, only Indonesia has cut rates, while five countries (Mexico, Brazil, Russia, Turkey and Czech Republic) have hiked rates.

In its latest policy statement, the Reserve Bank of India did hint that easing inflationary pressures have provided some “policy elbow room”, while reiterating that “at this juncture, policy support from all sides is required to regain the momentum of growth that was evident in H2:2020-21 and to nurture the recovery after it has taken root.”

It would therefore be reasonable to assume that as of today there is no certainty that the next rate move of most central banks would be a hike.

The actual decision to hike or cut policy rates is mostly dependent on real economic data, not perceptions and intuitions. Usually the hikes are after the economic activity has picked materially, output gap has shrunk and inflation has started become threatening. A rate hike under such circumstances is healthy, for economy as well as markets. There is strong evidence to indicate that markets have usually done very well after healthy rate hikes.

However, at this point in time the worrying aspect is not the probability of rate hike by Fed and other central banks. What is really disconcerting is the incongruence of policy minds. They are not able to define the primary threat to the stability of financial system and economy.

While the popular narrative is moving around inflation and economic recovery, there are distinctive signs indicating that the current inflation may be a supply shock and therefore is transitory.

Insofar as the economic recovery is concerned, it may be Schrödinger's cat. It is possible that the economic recovery is entirely based on the persistent infusion of abundant liquidity and prevalence of near zero or negative rate of interests. A hike in rates or significant withdrawal of liquidity might actually lead to the economy faltering. There is no way to test this hypothesis unless the rates are hiked or liquidity support is withdrawn; and no one would dare do that presently. I say so, because this could upset Ms. Market and she would certainly not like it.

This brings me to a very pertinent question “what is more important at this point in time for the policy managers – markets or sustainability?

Inarguably, one of the strongest pillars of the global economic recovery in past few years is the wealth effect created by rise in the prices of financial assets. Bonds, equities, and crypto currencies in particular have yielded superior returns, catalyzing the consumption and investments. Any event that might lead to material erosion of this wealth effect will be resisted by politicians and policymakers alike.

However, trillions of dollars in negative yielding debt, fiscal deficits running at arguably unsustainable levels, signs of unsustainability in asset prices must be bothering the minds and consciousness of the people on the side of righteousness. The innovative monetary policies adopted post Global Financial Crisis (GFC 2008-09) have miserably failed on sustainability aspect. The inequalities have risen to appalling levels. The dependency on government support for sustenance has increased even in most developed countries, as not enough sustainable employment opportunities are being created. The treasuries are riding the strongest tiger on the earth. They will have to find some innovative way to end this ride, before the tiger stops on its own to have a meal.

In this context, I note some interesting viewpoints:

Dr Lucy Hunt, a well-known economist has made a strong argument that deflation -- not inflation -- will win the day going forward, because the current debt, demographic and technological trends are very deflationary. The flood of new $trillions in monetary and fiscal stimulus are just not making it out into the real world. The fabled liquidity is just sitting in bank reserves and will continue to remain that way.

Dr Hunt said in a Webinar, “This reveals an important limit of central bank policy. There is a point of diminishing return at which the Fed is truly "pushing on a string". It can shove as much new money into the banking system as it wants, but there's no guarantee that money will make it out into the economy.

And as some of that money invariably finds its way into asset prices, causing them to inflate, corporate executives have a mal-incentive to invest their capital into financial assets vs productivity. The end result is that overall economic productivity is depressed.”

Lisa Beilfuss of Barron’s, raised a direct question at Fed. She wrote, “Investors are calling the Federal Reserve’s bluff. They are right to do so. The Federal Open Market Committee’s latest policy communications raised more questions than answers. Perhaps the biggest one: Can the Fed ever really raise interest rates?”… “The prospect of further fiscal spending would itself make tapering bond purchases a tall order. The Fed has become such a dominant force in the bond market and would presumably need to keep buying the additional debt as the Treasury incurs it. (The Biden administration has proposed a $6 trillion budget for 2022).”

There is strong evidence to indicate that a material part of price may actually be a supply shock and not demand shock, and may need more stimulus to mitigate. The infrastructure push of Biden, Xi Jingping, Narendra Modi et al, are all indicating towards this.

For records, US inventories are running at 30yr low. The shelves at supper markets are fast getting empty, mostly due to supply chain disruptions.

The demand for used trucks in US is feverish and prices are sky rocketing. As per Freightwaves, “New truck production, beset by shortages of microchips that power critical vehicle functions, and through-the-roof commodity prices, is only beginning to recover but manufacturers are having difficulties hiring enough workers.

It is in the context of this strong market that new truck production is struggling to keep up with strong demand and limiting the used truck market from realizing its full potential,” Tam said. “By all indications, demand continues to outpace supply, and for that reason, it should come as no surprise that truck prices continue to increase.”

Read our weekly report "Trekking Markets & More with InvesTrekk" here

 About a quarter of a century ago, I had just joined a midsized investment banking firm. My team of three people was assigned a mandate for IPO of a real estate company. We worked very hard (of course on our Excel Sheets and without the help of Saint Google) on the mandate and prepared a proposal which suggested that IPO may be priced in the band of Rs12-15. After the initial presentations were made, the team went to the promoter with the promoter of our firm for final presentation. After a detailed slide show was made, our boss told us to excuse them for 10minutes. After 10minutes, our boss came out and instructed, “IPO is in Rs28-30 band, prepare to file the documents for approvals.”

This being my first experience, for a moment I was in a position of shock. I found the pricing ridiculous. I even told my senior that this IPO cannot be sold at this price. My senior who had experienced many such situations before just smiled and told me to shut my mouth and get on the job. Eventually, the IPO was a success and the stock went on to become a compounder for the shareholders.

After reading and listening the expert commentators on various media platforms about the decision of the US Federal Reserve last night, I am getting a strong feeling of déjà vu. Millions of “experts” like me advised the FOMC about what they should be doing in the meeting and what the Chairman Powell should be saying after the meeting. But they have done and said what is most expedient for everyone – markets, government, economy and bankers. The novice may cry foul, but experienced ones know how does it work.

“Dot Plot” is a new buzz word that Indian electronic media has decided to learn. There are zillions of experts who are discussing the dot plot on social media platforms in India. It is heartening to note that we have become buzz word compliant.

“Dot plot” is a simple form of data visualization that consists of data points plotted as dots on a graph with an x- and y-axis. These types of charts are used to graphically depict certain data trends or groupings. US Federal Reserve uses this tool to present how the members of the Federal Reserve Open Market Committee (FOMC) perceive the benchmark bank rate over next few years.

The market experts discuss this “Dot Plot” intensively after every FOMC meeting. There is however little evidence to indicate that the actual trajectory of Fed benchmark rates has followed the dot plot. There is also little correlation between the actual trading positions and dot plot beyond 2days before and after the dot plot.

I like to compare the dot plot with the exit polls of elections in India. These are discussed intensively. They impact the market for two days (between exit polls and actual results). But there is little evidence to suggest that exit polls have a strong correlation with the actual election results; or any political strategy is formed on the basis of the results of exit polls..

The latest dot plot indicates that 13 of the 18 FOMC members believe that there will two rate hikes (from present 0-0.25%) in 2023, i.e., two years from now. 7 of the 18 FOMC believe that rate hike may actually happen in 2022.

I see there are many traders who want to trade on the basis of this dot plot. For all these enthusiast, my suggestions are as follows—

(i)    It is good to be buzz word compliant, but placing trade on these buzz words is not good idea.

(ii)   The actual decision to hike rates is always dependent on real economic data, not perception. Usually the hikes are after the economic activity has picked materially, output gap has shrunk and inflation has started become threatening. A rate hike under such circumstances is healthy.

(iii)  There is strong evidence to indicate that markets have usually done very well after healthy rate hikes.

For the record, FOMC has indicated that the US economic activity is recovering strongly. However, there is not enough evidence to warrant a rate hike in next 12months. A strong US economic recovery is good for global economy and markets; and continuing low rates and comfortable liquidity for next one year should continue to support the risk trade. Rest all is the TV discussion on exit polls.

US Federal Reserve Chairman Jerome Powell tried to set many speculations aside in his statement post the recent meeting of the Federal Open Market Committee (FOMC), Powell made the following three things very clear:

1.    US Fed policy Bank Rates, and therefore general rate environment, shall stay low till at least 2023.

2.    There is no threat of material rise in inflation in near term, and 2% inflation target shall remain valid till 2023. Even a temporary violation of 2% inflation target before 2023 shall not impact the decision to keep rates near zero till 2023.

This is in sharp contrast to the forecasts made by many global strategists, economists and fund managers, who believe that inflation could become a serious problem in 2021-22. In fact Powell expressed his concerns about the disinflationary pressures persisting.

3.    The job market is expected to improve and below trend unemployment rate of 4% shall be achieved by 2023.

The Federal Reserve however refrained from announcing any additional liquidity enhancement measures, including increasing the bond buying.

The consensus is reading the Federal Reserve's latest policy statement to mean that (a)   USD weakness may persist for some more time at least; (b) The market may continue to drive the Federal Reserve's action insofar as the monetary support (bond or stock buying etc) is concerned; (c) Powell backstop is there but may not be as strong as Draghi backstop.

This long term guidance by Fed must comfort markets and fuel the risk appetite of market participants. I would not like to read too much into the sell-off in markets post the Powell comments. It might be due to unwinding of the positions taken specifically for this event. No announcement related to enhancing Fed's asset purchase program may have disappointed many who were expecting Powell to announce this. But this is most likely a knee jerk reaction.

In this context, the recent statement of RBI Governor Shaktikanta Das is pertinent to note. Addressing to the National Executive Committee of FICCI, Das emphasized as follows:

"On the back of large policy stimulus and indications of the hesitant economic recovery, global financial markets have turned upbeat. Equity markets in both advanced and emerging market economies have bounced back, scaling new peaks after the ‘COVID crash’ in February-March. Bond yields have hardened in advanced economies on improvement in risk appetite, fuelling shift in investor’s preferences towards riskier assets. Portfolio flows to EMEs have resumed, and this has pushed up EME currencies, aided also by the US dollar’s weakness following the Fed’s recent communication on pursuing an average inflation target. Gold prices moderated after reaching an all-time high in the first week of August 2020 on prospects of economic recovery.

Financial market conditions in India have eased significantly across segments in response to the frontloaded cuts in the policy repo rate and large system-wide as well as targeted infusion of liquidity by the RBI. Despite substantial increase in the borrowing programme of the Government, persistently large surplus liquidity conditions have ensured non-disruptive mobilisation of resources at the lowest borrowing costs in a decade. In August 2020, the yield on 10-year G-sec benchmark surged by 35 basis points amidst concerns over inflation and further increase in supply of government papers. Following the RBI’s announcement of special open market operations (OMOs) and other measures to restore orderly functioning of the G-sec market, bond yields have softened and traded in a narrow range in September."

The governor was very guarded in his outlook for the economy. he stated, "high frequency indicators of agricultural activity, the purchasing managing index (PMI) for manufacturing and private estimates for unemployment point to some stabilisation of economic activity in Q2, while contractions in several sectors are also easing. The recovery is, however, not yet fully entrenched and moreover, in some sectors, upticks in June and July appear to be levelling off. By all indications, the recovery is likely to be gradual as efforts towards reopening of the economy are confronted with rising infections. (emphasis supplied)

Obviously, the incumbent governor does not concur with one of his predecessors Dr. C. Rangrajan who appears quite buoyant about the economic recovery in India.

What does it mean for Indian investors?

• Unless there is a Lehman type moment in global markets, the Indian equities may continue to remain supported.

• Precious metal trade should take a hit.

• The bond yields may remain stable, and RBI may maintain yields around current levels even if the food inflation shoots up in next couple of months.

• MPC may maintain status quo on policy rates in its next meeting, while continuing to maintain accommodative stance.

• Economic growth and therefore corporate earnings may not see a sharp recovery even in FY22.