Vijay Kumar Gaba

It’s almost a year since the Reserve Bank of India shifted the course of its monetary policy stance and embarked on the path of monetary tightening and withdrawal of accommodation to reign in runaway inflation. In the course of its journey in the past one year, RBI reversed the entire 250bps of rate cuts made during 2019-2020. 

Besides hiking the policy repo rate, RBI also enforced correction in banking system liquidity to check the demand side pressures on inflation. The banking system liquidity that was running in excess of rupees eight trillion a year ago, has been completely neutralized.

Impact of monetary tightening

It is very difficult to assess the direct impact of the RBI’s monetary policy action and its consequences. Nonetheless, it is pertinent to note how various sub segments of the economy have moved in the past one year. This movement could have been caused by a variety of factors, RBI tightening being one of them.

Inflation

The Consumer Price Index Inflation (CPI) has eased from 7.04% (yoy) in May 2022 to 5.66% (yoy) in March 2023. After mostly staying above the RBI tolerance band of 4% to 6% for more than 15%, the latest inflation reading is within the band, though still closer to the upper bound. If we adjust it for high base effect, material easing in global commodity prices, and significant improvement in supply chains, in the past one year, the direct impact of RBI policy on demand side pressure may not be material. Besides, given the chances of a below par monsoon due to development of El Nino in the Pacific Ocean, the food inflation may spike again challenging the sustainability of the recent fall in CPI inflation.

Money supply and credit

In the past one-year broader money supply (M3) in India has grown at a higher pace than the trend seen in the past one decade; and currently stands at INR227.8trillion.

The commercial banks have not passed on the entire 250bps hike in the policy repo rate to the borrowers. On average lending rates have risen 130 to 150bps. It is pertinent to note that movement in lending rates in India is mostly not in tandem with the policy repo rates. Lenders were also slow in cutting the rates while RBI was in easing mode. Regardless, now since the RBI has already signaled a pause, the probability of material rise in lending rates from the current level is low; implying that the policy rates are more of a signaling tool rather than a driving force for the commercial rates. The commercial rates are more of a function of demand and supply.

In FY23, the overall bank credit grew from Rs118.9trillion to Rs136.8trn, registering a growth of 15%, highest since 2014. Though some moderation in credit growth has been seen in the past one quarter.

The fastest growing segments of the bank credit in the past one year have been personal loans (especially unsecured loans) and financing to NBFCs, (much of this could also be consumer financing related). This clearly suggests that higher rates may not have deterred the demand much.

Growth

There is little evidence to show that the tighter monetary policy of the RBI in the past one year may have directly impacted the economic growth materially. Nonetheless, the growth momentum has definitely slowed down and is not seen picking up from the present low levels in any significant manner over the next 12months. Though the RBI has forecasted FY24 real GDP to grow at 6.4%; most private forecasters estimate the growth to remain slightly below 6%. Declining global growth and poor weather conditions could be the two major factors in the lower trajectory of growth.

Yield curve

The benchmark 10yr bond yields in India are now at the same level as these were a year ago. The short to mid-term yields (30days to 5yr) have risen sharply in the past one year. In the past six month in particular, the overall yield curve has moved down noticeably, except in the 30days to 1yr timeframe where the yields are still higher. Apparently, the poor liquidity in the banking system has resulted in higher near term rates, without impacting the demand materially – more of a lose-lose situation.

To conclude, I would believe that the aggressive tightening by RBI in the past one year, was more of a reaction to the global trend, ostensibly to preempt the outflows and pressure on INR, rather than to stabilize prices and calibrate demand. Given that USDINR has weakened by over 7% in the past one year; and foreign investors have been net sellers in the past twelve months, it could be concluded that RBI would have been better pursuing an independent monetary policy commensurate with the assessment of local conditions and requirements.

I understand the “not for this, things could have been much worse” argument fully and will reply to that some other time.

 Largely as expected; capex sustainability core focus (Phillips capital)

Budget fared well across categories – prudent fiscal position, steep rise in capex allocations, continued focus on sustainability, Atmanirbhar Bharat, and social upliftment.

Capex budgetary allocations have risen sharply in FY24 (up 37% vs. 23% in FY23); including IEBR, growth stands at 32%/10% in FY24/23. Incremental capex allocation in FY24 is highest for railways, roads, infra spending by states, and energy; defence and housing are muted; additional allocation of Rs 550bn has been made towards OMCs and BSNL capital infusion.

Sharp drop in food and fertiliser subsidy (Rs 1.6tn) is in the expected lines. MNREGA allocations have also see a sharp decline to Rs 600bn vs. Rs 894bn in FY23RE.

Fiscal deficit for FY24/23 is in line with our expectation – at 5.9%/6.4% of GDP; gross/net borrowing expectedly remains elevated at Rs 15.4tn/11.8tn, marginally higher vs. FY23. We expect this to keep yields elevated in the near future until clarity emerges on RBI rate reduction path (likely by Q3-Q4 FY24). State fiscal deficit limit has been set at 3.5% (including 0.5% for power sector reforms). Tax/GDP ratio at 11.1% bakes in all optimism, we expect marginal slippage considering likely economic softness in FY24. Revenue  expenditure/disinvestment targets are realistic, marginal slippage also expected under non-tax revenue.

Strategy

Buoyant public and private capex keeps us positive on the investment sectors (capital goods, railways, cement, logistics; defence is a tad soft – as expected) more than the discretionary segments. We are also positive on the agriculture space, government’s focus on raising domestic production, and eventually encouraging exports – is a long-term positive for rural income. Near-term, we are not positive on rural demand, FY24 allocations not encouraging.

Union Budget FY24: A Fixed Income and Macro Perspective (IDFC Mutual Fund)

Central government gross borrowing through dated securities is estimated at Rs. 15.4 lakh crore in FY24, well within market expectations, after Rs. 14.2 lakh crore in FY23 which was also devoid of any surprise. States’ borrowing could pick up in FY24 in line with potentially mildly-higher fiscal deficit, higher SDL redemptions and a possible shift from the pattern in FY22 and FY23 of a consistent undershoot the borrowing calendar. This implies consolidated (centre + states) gross borrowing, moving up each year after moderating from the peak in FY21, could now rise beyond FY21 and well above pre-pandemic borrowing (Figure 4). Even net consolidated borrowing as a share of GDP will be 1.1ppt higher than FY20 (pre-pandemic). Total outstanding government liabilities remain high at 82% of GDP at end of Q2 2022, after rising to 89% of GDP in FY21 and FY22 from 75% in FY20.

However, the central government is now in a position such that if nominal growth is in the 10-11% range and expenditure does not rise sharply in FY25 and FY26, it could well be on the fiscal glide path and get to below-4.5% fiscal deficit in FY26.

Strategy

While gross borrowing announced today has positively surprised versus market expectation, the standalone number is nevertheless a significant one. We expect the yield curve to steepen further somewhat, especially over the latter part of the year when market may have better line of sight on whatever modest rate cuts to expect if at all down the line; assuming a soft-landing scenario for the developed world.

The environment for fixed income is decidedly getting more constructive given better macro stability, terminal policy rates in sight, and the consequent fall in global bond market volatility. This argues for somewhat higher duration in active funds than before. At any rate one has to compensate for the ‘roll down’ effect on portfolio duration that happens when one is passively holding the same set of bonds. For these reasons, and keeping consistent with our underlying view, we have expanded our consideration set to 3 - 6 year maturity bonds; a marginal tweak from 3 - 5 year maturities before.

Pragmatic budget with focus on Growth and Macroeconomic Stability (Canara Robeco)

Budget has managed to create investment acceleration without damaging other expenditures. This was a modestly positive for equity markets. Consistent key positive for economy has been that Govt has been trying to focus on productive spending within constraints of resources over last 8 years.

Strategy

Budget is modestly positive for Industrials, Banks and both FMCG and non-FMCG discretionary consumption. Equity market will move back to two key factors from tomorrow, the earnings (season) and cost of capital (interest rate outlook globally). We think that both these factors are neutral to negative for us from near term perspective and thus market will continue to consolidate till we get visibility on earnings upgrades or substantial decline in interest rates (Inflation globally/locally) to change multiples. India trades at premium to other Ems and thankfully that is correcting with the consolidation over last 1 year. Indian equity market trades at 19xFY24 earnings – with earnings CAGR of 13-14% over FY23-25E – in a fair valuation zone from near term perspective.

Marching ahead on sustainable growth path (JM Financials)

The main focus area of Budget FY24 was on capex, with a substantially higher allocation of INR 10tn (33% YoY) while adhering to the fiscal consolidation path. The fiscal deficit target is set at 5.9% of GDP for FY24, but the way forward to FY26 would be steep.

Capex target for FY23 missed slightly (INR 7.3tn vs INR 7.5tn FY23BE) as states could not undertake the capital expenditure. The revenue growth assumptions (10.5% YoY) look optically conservative since it is on a higher base of FY23. However; over the FY23BE figures, the revenue growth rate comes to 22% which is quite stretched.

Strategy

We have a constructive view on the markets and we believe that the high allocation towards capex and schemes like PM Awas yojana are likely to benefit real estate ancillaries like cement and building materials while companies in the industrial space are the clear beneficiaries of the governments capex push.

Capex boom all the way (Yes Securities)

Continuing from the previous years, this Budget is a futuristic blueprint that seeks to harness the full potential of the economy through universal development and to touch the lowest income pyramid with inclusive policies. Impetus for job creation and macro stability remains the economic objective of the Budget making exercise. To improve the future productive capacity of the economy, effective capital expenditure has been increased to 4.5% of GDP or INR 13.7 tn, with outlay for railways and roads respectively up by 50.0% and 25.0% respectively over the FY23RE.

We see the budget maths as being rational with the nominal GDP growth assumed at 10.5% and laud the government for being able to stick to a consolidation plan at 5.9% GFD/GDP in FY24BE from 6.4% in FY23RE.

Strategy

The yield curve has flattened out significantly as the RBI has sharply increased the short-term rates. We see some scope for the yield curve steepening once again while holding the short-end of the curve. Tighter liquidity, larger general government issuances along with probable increase in the corporate bond issuances could be the factors behind steepening of the G-sec curve.

As in most years, we see the central government front-loading its borrowings into H1 FY24, thereby creating a possibility for the 10-year G-sec yields to rise to around 7.60-7.75% in that period.

Critical would be the demand from the insurance companies to clear the market supplies. We note that the incremental buying of the insurance companies in H1FY23 is lower than in H2FY22. The demand for guaranteed returns insurance policies could also die out as banks have raised their deposit rates now and tax arbitrage at higher end of term premia is done away with in this Budget.

Balanced Budget With Capex Led Growth (Kotak Mahindra AMC)

❖7% Growth expectation for FY23 looks Conservative

❖Focus on 3G

•      Growth - Fiscal consolidation & Infrastructure spending

•      Governance - Improving Tax Compliance

•      Green - Energy independence through green energy

❖Higher spending on Infrastructure than expectations to help Capex and Growth

❖Consumption to get a boost - Tax cuts

❖Multiplier effect on growth by pulling in private investment

❖Achievable divestment target of ₹ 610Bn

Strategy

❖Equity/Hybrid:

•      Indian Markets trading at a premium to other Ems

•      It’s a Buy on Dips Market

•      Allocate via Hybrid Funds such as Balanced Advantage & Multi-Asset Funds

•      Conservative investors can consider Equity Savings and Conservative Hybrid Funds

•      Exposure to Equity Funds preferred via SIP route

❖Fixed Income:

•      Market Linked Debentures will be taxed as Short Term Capital Gains at applicable rates. This will bring it at par with Debt Mutual Funds

•      Yield curve has flattened in the last 1 year, 3-7 years segment of the curve looks attractive

•      Short/ Medium Duration & Dynamic Bond Funds can be considered

•      Some allocation to Long Duration Funds can be considered in case the long-term yields harden further

Consistent, Credible and Prudent (IIFL Asset Management)

In line with the past few budgets, the government maintained its focus on capital expenditure to improve long term growth potential. While the headline capex growth seems higher (37% growth YoY), the adjusted budget spends are still higher by 25% YoY post internal adjustments, which is commendable. Further, a larger proportion of the capex has been provisioned for the central government (against spends by states and PSUs), which should result in better execution.

The FM maintained the trend of projecting realistic and achievable estimates, leaving the potential for an upside surprise if there is a pickup in economic activity. Tax revenues are projected to grow at 10.4% (vs 12.3% in FY23). Divestments targets also seem achievable at INR 610 bn (vs INR 600 bn in FY23). Improvement in global activity and peaking of interest rates could lead to upward revisions and lower deficits compared to projections.

Strategy

We maintain our focus on creating a balanced portfolio with a mix of companies which are likely to – experience structural growth or benefit from the economic turnarounds. In terms of sectors, we see interesting opportunities in Private Sector Financials, Consumer Discretionary, Industrials and Materials to participate in the domestic economic recovery.

We continue to maintain an overweight exposure to the secular segment (31% portfolio vs 21% for benchmark) and remain underweight in value traps (20% vs 31%) across most of our portfolios. Our portfolios are also overweight cyclicals (22% vs 16%) vs defensives (25% vs 32%), we expect this trend to continue in the near term.

Growth support; fiscal consolidation (DBS)

The central government’s FY24 Budget was growth supportive whilst sticking with a

modest glide path for consolidation. The underlying math was reasonable as it factored

in the upcoming moderation in nominal GDP growth, and lower tax buoyancy, whilst prioritising long-gestation capex spending.

Accompanying sectoral announcements were a mix of tweaks to the personal income tax brackets (to provide support to the salaried class), changes in custom duties to support local manufacturing, and targeting green transition goals, which was balanced by higher allocation towards MSME credit guarantee schemes, skill upgradation and other inclusive welfare goals. The medium-term path of further fiscal rationalisation remains in place as the government reinforced its target of lowering the deficit to -4.5% of GDP by FY26.

Strategy

The high contribution of small saving scheme might be at risk as banks continue to offer competing deposit returns. Looking ahead, market conditions might be less conducive in FY24 on account of a narrower liquidity balance, squeeze on banks as credit growth continues to outpace deposit generation hurting incremental demand for bonds as well as limited progress on global bond index inclusion plans. This increases the likelihood that the central bank might show its hand via open market operations in the course of the year to contain unexpected volatility.

The Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) is scheduled to announce its latest assessment of the economy and its policy stance tomorrow. A large number of market participants are waiting to hear the Fed chairman, with bated breath. I expect a large number of traders in India to stay awake till midnight to hear Mr. Powell, even though they cannot initiate any trade until 9:15AM on Thursday, when the Indian markets open for trading. Therefore, literally speaking, losing sleep to hear the Fed statement is of little consequence.

The market consensus is for a 75bps hike in the policy bank rate and an unambiguous hawkish stance unlike the previous statement in July, when the Fed sounded little ambivalent about the future hikes. Some experts are expecting even a steeper 100bps hike and raise in the terminal bank rate target to 4.5% (from previously estimated 3.75-4%) by April 2023. This implies a total of 200bps expected hike between September 2022 and April 2023; the steepest hike in the past two decades.

Since March 2022, when the Fed started to hike rates to bring down the inflation, an interesting contest has been seen between markets and the Fed.

1.    The benchmark S&P500 has moved higher after hearing the Fed on 3 of the 4 occasions. Obviously, the messaging of the Fed to the market was lacking in clarity and intent.

 

2.    One of the reasons for defiance of stock prices despite sharp rate hikes is that the Fed has not been able to materially influence the long term yields so far. The US yield curve has inverted sharply in the past six months, indicating that the markets are assuming a sharper recession and a quick reversal in the rate hike cycle (as early as 2H2023).

3.    The commodity prices have not yet corrected in line with the stance of central bankers and forecasts of severe recession. Bloomberg Commodity Index is still higher than the level it was at the beginning of the rate hikes in March 2022; and so has been the inflation. Consequently, the US rates have become sharply negative severely hurting the savers.

 

Obviously, more than the action, the Fed perhaps needs to tighten its messaging to the markets. For example, a clear message that the inflation is not seen coming below the Fed’s upper tolerance band at least till the end of 2023 and it would not be prudent to expect a rate cut before 2Q2024, could make the market reactions more congruent to the Fed’s policy stance.

The market participants in India must be relaxed after a strong equity market rally in the past 4-5weeks; and stable INR and bond markets. To that extent the RBI has played its part rather well. It has repeatedly reassured the markets about its commitment to the economic growth and stability in the financial markets. Despite turmoil in the global energy and food markets and geopolitical concerns, the RBI managed to contain the volatility in currency and debt market to very moderate levels.

With this background in mind, the market participants are obviously complacent to the likely outcome of the meeting of the Monetary Policy Committee of RBI this week. It seems to be a consensus view that the MPC may use some stronger words to express the concerns about rising prices and exacerbated fiscal pressures, but may stop short of hiking policy rates or changing its accommodative policy stance. Given the fragility of the economic recovery and elevated global uncertainty, the last thing RBI would want to do is to make a disruptive move.

Nonetheless, the participants in the equity markets must be keeping a close watch on the developments in the bond markets. The bond yields have been rising ever since the RBI announced government’s borrowing calendar for 1HFY23. The government is likely to borrow Rs8.45trn form the market in next 6months. This is about 59% of the total budgeted borrowings for FY23. A view is developing that notwithstanding the robust tax collections and consistent alignment of fuel prices to the market prices, the government might need to borrow more than the budgeted due to higher farm and food subsidies. Accordingly, the yield curve in India is very steep in the 1 to 10yr maturity band and mostly flat in the 12-30yrs maturity band. This is in sharp contrast to the inverted yield curve in the US.

As per the conventional wisdom, an inversion in yield curves (2yr yields higher than 10yr yields) usually precedes recession. A steeper yield curve on the other hand reflects expectations of a stronger economic activity and therefore higher inflation in the short term.

The impact of a steeper/inverted yield curve could however be different. As per the conventional wisdom the stock market factors in the future events well in advance. The earnings forecasts and stock prices are adjusted to factor in all known future events. Of course there is subjectivity in the analysts’ assessment and pricing methods used, recognition of the event itself is usually uniform, with very few contrarian views.

It is therefore reasonable to believe that the US equities are already pricing in a recession in next six months and may not see much correction from the current level despite few rate hikes by the Federal Reserve. Whereas, the Indian equities might be pricing in a stronger economy and there could be some scope for disappointment. A rise in benchmark yields to 7.25-7.5% (as presently forecasted by most analysts) could cool the heated equity markets.

However, this view is subject to deftness of RBI in managing the bond market. Higher FII allocation; continued use of innovative tools; and a sharper global commodity price correction could keep the bond yields under check (or even result in lower yields) and fuel the equity prices further.

Whatever be the case, for sometimes the bond market may be the guiding factor for equity markets.

 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.”

In a significant move for the banking industry, the central government has proposed to lift the embargo on grant of government business to private banks. Whereas, de facto the government has always favored public sector banks for grant of government business, the de jure embargo was imposed in 2012 post global financial crisis to protect the small savers and public entities from a potential collapse. Initially the embargo was imposed for a period of 3years; but it was extended further in 2015; through some private sector banks with public sector legacy (ICICI, Axis etc) were continued to be permitted to conduct some part of the government agency business. As per the latest announcement, the embargo is proposed to be lifted completely.

This announcement has come at a time when the government would be starting the process privatize couple of public sector banks (PSBs), and diluting its shareholding in other PSBs. In past couple of decades, many public sector undertakings have faced serious consequences due to dilution of government patronage to their business and/or introduction of private sector competition in their field of operations, e.g., Air India, BHEL, BEML, STC, MMTC etc. Obviously, lifting of this embargo will seriously impact the profitability of many smaller PSBs. Even larger PSBs will be impacted to some extent. The already subdued valuations of PSBs will naturally get further discounted. Banks like Jammu and Kashmir Bank, which substantially rely on government business, could face serious issues of sustainability.

The moot point therefore is whether liberalization in grant of government and public sector business must inevitably result in destruction of public sector wealth, or the liberalization could be better managed.

On a different note, RBI appears to be quite concerned about the financial markets and economic growth. RBI governor has been categorical in cautioning about crypto currencies. He has also raised the issue of divergence between performances of economic performance and stock market repeatedly. He has also raised concern over second round effect of fuel prices on economic growth.

Whereas, the financial markets and bond markets are fast pricing in an economy “overheating” scenario with sustainable rise in inflation, RBI has reiterated its commitment to continue with “accommodative” policy stance. In recent past, multiple bond auctions by RBI have devolved due to lack of demand at RBI cut off yields.

Obviously there is a divergence in RBI and market’s outlook about the price and yield scenarios. This implies either of the following two scenarios:

(i)    RBI is running behind the curve. If this is the case, the market shall be ready for a rate shock, whenever RBI does the catch up Act. Last time I remember this happened was during Subba Rao tenure, when multiple hikes were implemented in short span of time.

(ii)   RBI assessment of economic and earnings growth is closer to reality. In this case, also markets may be surprised negatively as it is pricing in a sharp recovery in earnings over FY22-23.

Historically, the disagreements\ between market consensus and RBI have not ended well for markets. I hope, this time it is different.