Vijay Kumar Gaba

 The yields curve in India has been moving higher for past few months, despite the efforts made by the Reserve bank of India to anchor the benchmark yields at lower levels. In past one year, the RBI has used most of the arrows in its quiver to manage the bond yields, apparently with the three targets in view – (a) to help the government fund its fiscal expansion at reasonable rate; (b) to keep the financial markets calm in the times of adversity; and (c) to keep the rate environment supportive of growth.

However, last week the RBI appears to have changed the trajectory of its policy by accepting higher coupon (6.10%) for the new benchmark security (6.10GS2031). This move is widely expected to result in India’s yield curve inching little higher, and perhaps flattening a bit.

The debt market traders have largely seen the latest move of RBI as the rise in its tolerance for higher yields. Though the governor has maintained that RBI is committed to keep the borrowing cost for the government under control, and focusing on the benchmark 10 year yields for yield directions alone may not be appropriate.

The minutes of the last meeting of Monetary Policy Committee of RBI clearly stated that “all members of the MPC unanimously voted to continue with the accommodative stance as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward”. The governor specifically stated that “At this juncture, providing a policy environment supportive of sustained economic recovery from the second shock of the pandemic is necessary.” It would be reasonable to infer that there is no certainty about the next move of the MPC on policy rates. If required it could be a cut also.

The global trends in bond yield have been providing mixed signals. Despite, the concerns expressed by the top central bankers about the rising inflationary pressures, the bond market have remained generally buoyant. People’s Bank of China has in fact went ahead and cut the key reserve ratio, committing to the growth disregarding the inflationary pressures.

In the year 2021, so far seven major central banks have effected change in their policy rate; out of which six (Brazil, Czech, Hungry, Mexico, Russia and Turkey) have hiked the rates and only one (Denmark) has cut the rates.

The US Federal Open Markets Committee (FOMC) has indicated that its next move could be a hike; though it not happen in next twelve months at least. The European Central Bank (ECB) signals are though mixed.

What does a tolerant RBI mean to markets?

In recent months, the inflation in India has mostly remained above the RBI’s tolerance range. The MPC committee has repeatedly reiterated that for now the growth remains a priority. Nonetheless the rising price pressures do find a strong mention in MPC commentary. Inflation has persisted above RBI’s base target of 4% for more than a year now. For FY21 as a whole, it has remained above the tolerance range of 4%+/- 2%.

The fiscal expansion in the wake of economic crises that emerged due to the pandemic is yet another cause of worry for the monetary managers. S&P Global has estimated that for FY22 the fiscal deficit of India may remain elevated at 11.7% of GDP. This is much beyond the limits envisaged under the Fiscal Responsibility and Budget Management Act (FRBMA). It is pertinent to note that for FY21, the general government fiscal deficit of Indian government amounted to 13.3% of GDP (S&P expects it to be 14.2%). Obviously, the fiscal pressures may also be weighing on the RBI mind.

In recent months there have been many occasions when the RBI auction of government securities has devolved on the primary dealers.

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(a)   RBI is not getting enough demand for the benchmark 10yr securities at 6% or lower coupon.

(b)   RBI is finding itself behind the curve, since it effectively enhanced its tolerance to inflation, without making corresponding adjustment to the bond yields.

(c)    RBI is preparing the markets for the likely global monetary tightening. Even though the large global central bankers may not cut the policy rates in next twelve months, there are decent chances that they taper their bond buying program, leading to unwinding of some of the USD and EUR carry trade. A higher yield could be a good incentive for global investors to stay put in Indian gilts.

(d)   After accepting higher yield for benchmark 10yr securities, RBI may also desire a little flatter yield curve, which means rising yields at the middle of the curve. This may be desirable considering that the steeper yield curve may be acting as a disincentive to raise long term funds.

What could be the trade?

One of the obvious trades would be to increase the duration in debt portfolio to protect it from flattening of yield curve.

The other trade would be to invest in dynamic bond funds (debt counterpart of the Flexicap equity funds).

Insofar as the equity market is concerned, theoretically equity valuations ought to respond negatively to the rising yields. But in practice the correlation is not seen to have worked in many instances.

Theoretically, the higher bond yields should result in higher opportunity cost for owning equity. The probability of lower future return would make the trade relatively less profitable resulting in investors moving more allocation to the bonds. However, this may not work in the present circumstances due to a variety of factors. For example—

·         The yield curve is too steep presently to have any meaningful impact on the equity traders’ opportunity cost.

·         Even at the 5-6yr maturity, the real yields continue to be negative, whereas the equity returns are projected to be decent for next couple of years at least.

·         Higher benchmark yields are not likely to transmit to the lending rates in a hurry, given the poor credit demand and massive accumulation of reserve money with the banks.

·         The leverage in the equity markets is significantly lower as compared to previous rate cycles. Any large unwinding is therefore unlikely in the short term.

·         Despite the acceptance of higher benchmark yield, RBI remains committed to support the growth. Since the growth is not likely to reach the desired levels anytime soon, any meaningful tightening by RBI is highly unlikely, notwithstanding the pricing pressures.

The market has read this very well and refused to react negatively to higher yield. It is reasonable to expect that this status quo may prevail.

Is RBI running behind the curve?

The more pertinent question however is “whether RBI is running behind the curve and the economy will have to pay for this lag later in the day?”

In my view, the historical evidence indicates that most central banks usually like to remain behind the curve rather than jumping the gun. There are very few instances in the history of RBI when it has preempted the inflation and hiked beforehand. I will therefore not be unduly worried about RBI running little behind. Besides, RBI would not like to relive the experience of 2011 when the rates were hiked prematurely and the required a hasty retreat.

It is true that RBI will need lot of luck with inflation in next couple of years. The premise that “inflation is transitory” and pressures will ease as the global economy opens up more in next 6-9 months, must come true to make RBI’s task easier. Else, we shall be ready for an undeniable “Stagflationary” phase in the economy. Remember, the Indian economy is already facing a sort of stagflation, but it has been mostly denied.

What the Global trends say

Last weekend, Peoples Bank of China (PBOC) surprised the market by cutting the reserve requirement ratio (RRR) for all banks by 50 bps, releasing around 1 trillion yuan ($154 billion) in long-term liquidity. The analysts widely view the move as an attempt to sustain the post pandemic growth momentum which had shown some sign of fatigue in recent data.

As per the UBS EM strategist, "China was first in, first out (with COVID policy support) - it effectively started tightening (monetary policy) in Q3 last year - so now it is possible that the message is, if you are thinking about global significance, that the PBOC is showing that economies are still somewhat fragile and inflation is not likely to be too damaging over the medium term."

The Researach Analysts at Ashmore Group, London feels “The 50-bps cut in reserve requirement ratio came slightly earlier than most expected. China is likely to ease monetary policy via RRR cuts and OMO operations in order to allow for more local government bond issuance. This will support strategic infrastructure investment such as railways and 5G rollout. We expect fiscal policy to remain focused on specific sectors most affected by the pandemic like small companies. We also expect macro prudential tightening on the property market to remain in place.”

US yields are now at 2% or below across maturities and appear falling towards lows seen 6 months ago. Obviously the market does not believe that Fed would actually care to hike rates earlier than 2023. The market consensus also seems to be concurring with the Fed’s view that inflation is transitory and passé by end of 2021.

The Minutes of the recent FOMC meet suggest that while tapering of QE is on the table, but few Fed members are in a rush to actually do it. The statement read “The overall mindset was tilted towards patiently watching the progress of the economy and labor market, and providing ample adjustment time to the markets. Given the current condition of the labor market and the inflationary pressures, we reiterate our view that tapering could start early next year with the announcement coming in August-September 2021.”

Many analysts are sensing an economic signal from the plunging yields in US, with the simultaneous surge in the dollar. The evidence is rising that the reflation trade may be getting unwound.

There are some dissenting voices, like an analyst at Bridgewater Associates’, who believes that “Bond markets are sending a clear message that inflation is transitory but investors should prepare for the possibility that they're wrong”.

Bill Blain (morningPorridge.com) was even more candid. He writes, “The brutal reality is the Central Bankers, who are all honourable men and women, understand the levers they pull no longer function as they once did. Why? Well, these honourable men and women have broken the system as a consequence of their actions. Oops. Now they have no choice but to follow.. which means trouble ahead until the global financial system can be resolved.”

“Most of the market is fixated on what the S&P does this afternoon, what new high the NASDAQ will make this month, or where Amazon is going to top this quarter. They have the vision of a blind man when it comes to anything much beyond the end of their one-year time horizon. Even the bond market seems blind.”

In the meantime, fissures have emerged in the ECB’s unity over inflation target. As per media reports, “European Central Bank unity on its inflation target could dissolve into division as early as next week when policymakers meet to discuss changing its guidance on raising interest rates.”

“In its recent policy review, ECB has set 2% as the inflation target and will allow overshoot of this target as necessary. This marks a change in long established stance –since 2003, ECB has kept an inflation policy stance of “below, but close to 2%”. The recent surge in cases across Europe, if uncontrolled, could throw off Eurozone from recovery path and continuation of QE will be key.”