BY SUYASH CHOUDHARY
“I know delusion when I see it in the mirror”:
Taylor Swift
And the book cautions against the temptation to start easing policy at the first sign of inflation softening. Irrespective whether that
literature is relevant today, this is the best that central banks have to go on. Also, to be fair, unanchored inflation would open up a
box that would be much more difficult to close than growth collapsing for a while. If the problem is the latter, central banks will be
back into familiar territory of operation. Thus their reaction function ahead will be decidedly asymmetrical, with much greater
tolerance for continued growth slowdown and much lesser for any interruption to the pace of disinflation.
Indeed, the Fed Chair has said as much clearly articulating preference for running the risk of overtightening (which can be
unwound later through tried and tested tools) versus finding out that enough tightening wasn't done (which would take macro
dynamics into unchartered territory). One wonders whether enough ‘skew' is there towards this eventuality in market's current
probabilistic distribution of future outcomes.
THE GROWTH DELUSION
If it isn't apparent by now, here's an explicit admission: there is some force fitting of section titles here to be consistent with the
theme of the piece. This may make the headlines sound harsher at times than how they are intended. On review we find the same
admission in last year's piece as well. Chalking this then down to the perils of writing theme-based end-of-year notes, and with this
warning in place, we must plod on.
Higher inflation has brought higher nominal growth rates this year. There has, no doubt, been an underpinning of higher demand
as well. However, the effect has been somewhat exaggerated when one has looked at nominal variables, owing to the inflation
component. However, as one looks ahead it is likely that nominal growth rates come off sharply. This will be both on account of
inflation falling as well as real growth rates weakening. Nominal interest rates may fall as well, but it is unlikely that this will happen
as sharply if the discussion above proves to hold true.
Although hopefully temporarily, but this will on the margin make debt servicing that much more onerous. Nominal revenue
assumptions going into budget making exercises will need to take this into account, with the obvious risk being that, after handsome
overshoots this year owing to much higher than anticipated inflation, there is a tendency to overestimate these for next year. Central
banks, especially in developed markets, who have had a ‘free hand' thus far in addressing inflation may find the environment much
less conducive next year.
As nominal incomes experience the force of gravity and job losses start to bite, it may get that much more difficult to explain the
necessity of persisting at peak rates; especially as this would happen not at (say) 7 per cent inflation but at (say) 4 per cent. There
may be more fractures within monetary policy committees (MPCs) themselves and more dissents to the eventual decision.
Again, these are less relevant for India but worth a discussion nevertheless. Dissent has already surfaced on policy but given that
our MPC is only tasked with setting the repo rate and vocalising the stance, there is only so much additional differences of opinion
one can have. This is especially as, if our view is right, we are already at peak cycle repo rate or at worst 25 bps away from it.
Once stance turns to neutral, it is likely that for a while action shifts back to RBI measures as opposed to MPC ones, as was true for
most of the pandemic period. One of the key things markets will watch for next year is when, how, and by how much RBI chooses to
augment system liquidity (core liquidity would have been very close to zero by then). As the year progresses it is possible that MPC
discussions get more active again. This is in context of our view that though India will relatively do better on growth than most places
around the world, we will nevertheless slow as well reflecting the global slowdown. Basis this we also believe that the general view on
domestic growth for next year (including from RBI) is a shade too optimistic.
A LOOK BACK AT OUR OWN DELUSIONS…
Over the first part of 2022, there were two factors that weighed on us: One, we were cognisant that a policy normalisation cycle
was coming and were on the lookout for active duration management opportunities to help curtail potential portfolio volatility from the
same. Two, the yield curve was steep with the 4-5 year maturities seemingly providing enough cushion against an eventual
normalisation of RBI repo rate towards the pre-pandemic level of 5.15 per cent.
The same steepness meant that the carry loss in running cash positions was significantly large whenever one chose to take cash
calls in pursuit of navigating volatility. In this context, stickier dovish RBI commentary (refer February 2022 policy as an example,
https://idfcmf.com/article/7085) and reluctance to take the first meaningful step towards rate normalisation heightened the carry loss
aspect especially since, as mentioned above, 4 year government bond valuations (between 6 – 6.25%) seemed to have enough
protection already built in, in a scenario of a slow normalisation cycle to early 5 per cent's on the repo rate.
Our delusion, as it turned out, was to not allow for longer periods of cash calls, assigning greater weightage to carry and valuation
considerations mentioned here versus the steadily rising prospects of global volatility. Consequently, we suffered the full impact of the
bolt from the blue that arrived in May in the form of an inter-meeting hike in both repo and CRR. This also served to un-anchor terminal
rate expectations for the market. In fact almost the entire brunt of rise in yields (save for in the very front end) was felt over
approximately just one month between early April and early May. Our most overweight government bond's yield as at time of writing is
approximately at the same level as it was in early May, but rose roughly 100 bps over the one month prior to that.
This has probably been one of the more passive years for us in terms of changes to investment strategies. That is because once
the damage was done over the short period of one month early in the year, the focus then shifted to reassessing the underlying
framework to see whether one should now turn reactive and ‘cut out'.
While our own assessment of terminal RBI repo rate has been revised higher through the latter part of the year, there were
nevertheless certain underpinnings to our framework that we held on to. For one, and even as the Fed rate cycle has turned out to
be stronger than earlier envisaged, we rejected the idea that India needs outlier rate hikes (or be in lock-step with the Fed),
supposedly to defend the rupee. Reasons behind our thinking have been documented through the year in our various investment
notes (as an example, https://idfcmf.com/article/9850).
We were looking at the post Covid evolution of India's fiscal and monetary response and didn't find this to be at all excessive,
especially when compared with what went on in developed markets. Thus we were comfortable with the idea that at cycle top RBI to
Fed policy rate differential can actually be quite narrow, even as it will widen again later on as US inflation comes off and the Fed
finds more room to cut than us down the line.
This is because the current cycle peak in Fed funds rate is much higher than their long term neutral compared with RBI's cycle
peak compared with our long term neutral. As the year closes, we are happy to see this idea having more traction with most of the
market now comfortable with the idea of a 6.50 per cent – 6.75 per cent repo rate peak against Fed's 5 per cent. This importantly in
turn has lent stability to our investment strategies.
… AND A LOOK AHEAD TO (POTENTIALLY) NEW ONES
The residual ‘nit-picking' that remains with respect to terminal policy rate expectations in major markets (including our own) will
hopefully be put to rest in the first few months of the new year without any major further disruptions. Attention will then shift from
‘how far' to ‘how long'.
To state the obvious, the primary driver for expectation changes will be material shifts in inflation and not the continuation of
growth slowdown. In the meanwhile financial conditions may remain tight driven by high nominal policy rates and continued central
bank balance sheet shrinkage. The latter may indeed require more general attention than has hitherto been given, including in India.
Importantly, this will happen at much more subdued nominal growth rates. This may weigh much more on the more fragile balance
sheets and business models than hitherto has been the case.
Put another way, unless the market expectations channel shifts materially and quickly which seems improbable at this juncture,
central banks holding a far higher than neutral nominal rates and progressively shrinking balance sheets will continue to impart
tightening pressure without any additional actual rate hikes. The bulk of the pain from this unprecedented rate hike cycle is thus
ahead of us in terms of its effect on balance sheets and general economic growth.
In sum, though there is a path towards a ‘Goldilocks landing' that we explored above basis summary of various market rates and
spreads, this is by no means given. There is a very good chance that the battle against inflation lasts longer, and may continue to be
fought much beyond the peak in policy rates via continuation of those rates for longer and progressive central bank balance sheet
shrinkage even as nominal growth rates begin to come off meaningfully. Thus in some way the focus will shift from obsessing on
peak rates to watching for where and with what intensity damage starts showing up from this unprecedentedly sharp developed
market tightening cycle.
Needless to say, the longer it takes for the Fed to turn the more the likelihood of such damage. The risk, as discussed here, is
that markets globally aren't giving enough importance currently to this period between the end of tightening and the start of easing
which may still require very careful navigation.
China will likely continue running an economic cycle that provides counterbalance for the rest of the world, in some sense. Thus
Chinese GDP slowed markedly over this period of stimulus fuelled developed market growth, and is set to accelerate sharply probably
over second half of the next year once the anticipated disruptions around opening from Covid play themselves out and the full effect of
ongoing policy stimulus starts to get felt. By then most of developed world in turn would have slowed aggressively.
While US slowed less than earlier expected this year owing to an underestimation probably of the accumulated transfers sitting in
consumer balance sheets, Europe saw meaningful fiscal response to partly shield the economy from the energy crisis. Apart from
central bank tightening, both these effects are set to fade over the year ahead thus providing further drag to these economies.
For our own market, while peak repo rate is in sight (or may be already in place) it may also have to be held at that level for some
time. As noted above, the world will still likely be a very challenging place which argues for continued vigilance on macro-economic
stability. Fiscal policy will also have to keep this in mind. While on the one hand, a large part of additional revenue spending to
absorb the acute commodity shock this year will not recur next year, on the other nominal growth rates will come off significantly as
well.
Alongside, the government will have to continue with fiscal consolidation in line with the medium term compression path
indicated. Even as the environment will likely still remain challenging, at least for the first part of the year, we expect a lot of the
macro-economic concerns from this year to abate into the next. The current account should become more manageable whereas the
path to lower inflation should become clearer.
From the perspective of investors, this is for the first time in the recent period that more attention may start to get paid towards
liquidity of holdings. This observation is made more in a generic, global sense but may not be entirely irrelevant in a local sense as well.
Credit spreads have fallen sharply in India as well owing to a variety of reasons: Balance sheets have cleaned up in many cases
thereby improving credit perception. The consequent deleveraging has automatically reduced paper supply.
A lot of capex that used to happen via public sector entities has been taken on directly into the centre's budget in order to improve
transparency. This has meant lower issuances by these entities and higher government bond supply, ceteris paribus. Some part of
financing has shifted from bonds to bank credit reflecting both keener appetite from the latter to lend as well as heightened market
volatility this year.
Finally, investors have demanded lower liquidity discounts given the generally easy liquidity environment. Some of these factors
may very well be turning. Bond supply from both banks as well as companies is picking up. While there is not much of an
observable shift in investors' liquidity preference yet, we expect this to gain traction over the next year. Also as attention shifts to RBI
having to infuse permanent liquidity down the line, some natural preference may emerge as well for sovereign assets in one's
preferred duration bucket, especially if credit spreads aren't particularly attractive.
Given this framework, we continue with our preference for government bonds in the 3 to 5 year maturity segment as we turn the year.
For longer duration bonds to rally sustainably, market may need visibility on rate cuts since a starting spread of 100 – 125 bps of 10 year to
overnight rate doesn't leave much scope on its own. Should the developed world head towards a ‘hard landing' scenario, then this could
very well be possible.
However, we don't have that visibility yet from our current vantage point. Also there's a good likelihood of yield curve steepening
in that scenario if the accompanying fiscal compression in India isn't very meaningful owing to growth concerns. Corporate spreads
have opened at the very front end due to the very large supply of bank CDs, but are still very modest for longer durations. We
expect that these should start opening up as well as we head deeper into the new year.
And so another year closes. For some time now one hasn't quite got the feeling of having quietly closed one door and now gently
turning the knob on the next. Nevertheless there is this door in front and here's to hoping that you enter in good health, that inside
you are greeted with cheer and embrace, and that the warmth of the room carries you through the year.
(The author is the Head –
Fixed Income, IDFC AMC)
