There has been a lot of debate about the dramatic re-emergence of inflation and its impact on monetary policy. Economists, market experts, media commentators, and even policymakers are divided about the sustainability of the current elevated inflation trend. Yet, central bankers across developed and developing economies have termed it as a ‘transitory’ phenomenon.
This gives them flexibility to be more tolerant of inflation and continue with the historically low policy rates and abundant liquidity policy. This can be seen in the following statement by the RBI governor Shaktikanta Das, made during the monetary policy announcement on August 6, 2021:
“The recent inflationary pressures are evoking concerns; but the current assessment is that these pressures are transitory and largely driven by adverse supply side factors... At this stage, continued policy support from all sides – fiscal, monetary and sectoral – is required to nurture the nascent and hesitant recovery”.
And the Normalization Begins
Although the Monetary Policy Committee (MPC) maintained status quo on policy rates, the split in the MPC voting in the August 2021 meeting from 6-0 to 5-1 on keeping policy stance ‘accommodative’ and the announcement to increase the quantum of Variable Rate Reverse Repo (VRRR) auctions suggests that thinking within the RBI on normalizing monetary policy has begun.
Over the next six months, we would expect RBI to reduce the excess liquidity in the banking system. We would expect an increase in the reverse repo rate from 3.35% to 3.75%, a subtle move away from the accommodative stance to neutral and then to a gradual beginning of rate hikes.
Chart – I: Policy Rates set to move higher
Source: CMIE, Quantum Research | Data up to July 2021
This sequence of monetary policy normalisation is now almost consensus. Certain segments of the bond markets have already priced in some of the near-term impacts of these forthcoming actions. However, performance of the fixed income assets over the next 2-3 years will be determined by the extent of policy normalisation and its impact on interest rates over the long term. This takes us to another pertinent question - What will be the new normal for interest rates?
The New Normal
In a recent article, Arvind Chari (CIO, Quantum Advisors) shared his perspective on what would be the new normal for interest rates in post-pandemic India. He argued that the RBI will be slow to act and try to indicate to the markets that a policy rate of 5.0% in itself may be the ‘new normal’. (https://www.qasl.com/post/the-post-pandemic-new-normal-for-rates-in-india)
Furthermore, RBI governor Das’s characterisation of the yield curve as a ‘public good’ suggests that even when policy rates eventually rise, the RBI will continue its market interventions and keep firm control on government bond yields.
Chart – II: OMOs to control bond yields
Source: RBI, Bloomberg | Data Upto July 2021
OMO= open market operations - Government bond purchases by RBI
As we look out over the next year, we do see interest rates moving higher. Reduction in surplus liquidity and hike in policy rates should push the short-end bond yields significantly higher than where they are today.
However, if indeed, the Repo rate gets held at 5%, interest rates will settle much lower than their long-term historical average. This will have significant implication for returns from fixed income instruments over the medium to long term. Investors should adjust their expectation to the new reality that interest rate on fixed deposits and returns on debt mutual funds will be lower than what they used to be.
Looking Beyond Macros
From the bond market's perspective, it is time to look beyond the current macro developments and potential policy changes. The Yield curve is currently steepest since the aftermath of the global financial crisis.
Chart – III: India Sovereign Yield Curve is steepest in a decade
Source: Refinitiv, Quantum Research
This means there is very low yield/accrual at the short end of the yield curve while the longer end is still offering a fairly high yield in the current low-rate environment.
For instance, the 30-year government bond is currently trading at ~7.2%. It implies a yield spread of +320 basis points over the current Repo rate of 4% and +220 basis points over a ‘prospective’ Repo rate of 5%, which may possibly be attained by the end of next year. Even the 15 year government bond is currently trading at ~6.9% would be at a much higher spread over the ‘new normal’ policy rate than its long-term average.
Chart – IV: Term Spreads are at decade high
Source: Refinitiv, Quantum Research | Data up to August 13, 2021
On the surface, this looks like a great investment opportunity. However, excessive allocation to long-term bonds will expose investors to high market risk in a rising rate environment and could result in a considerable loss in portfolio value if things go the other way. Thus, it is critical to have a balanced and dynamic approach in building a fixed income portfolio.
Balanced and Dynamic Allocation.
Given the above market view and need for balanced risk exposure, Quantum Dynamic Bond Fund (QDBF) is currently positioned as a barbell. Under this strategy, a part of the portfolio is invested in 25-30 year bonds; while a large portion is invested in very short term (below 2 year maturity) bonds. The portfolio is also maintaining a larger than usual cash buffer at this point to exploit any market mispricing emerging out of changing policy direction.
In our opinion, the longer term bonds are attractively priced and have potential to gain over the medium to long term. Exposure to short-term bonds is a balancing position to lower the overall portfolio duration or sensitivity to interest rate changes. We have tried to avoid the intermediate maturity segment, which in our opinion is highly sensitive to change in policy direction and likely to be a poor performer in the next 6-12 months.
“Uncertainty is the only certainty about future”
We understand that the economy and markets are currently adjusting to an unprecedented shock. There are too many moving parts and things are still evolving. Thus, any forecast about the future is susceptible to change based on policy responses from the government and the RBI and the changes in global markets.
We stand vigilant to review our outlook as and when new information comes. We retain our right to remain dynamic in our portfolio construction to respond to the evolving economic and market conditions.
For any queries directly linked to the insights and data shared in the newsletter, please reach out to the author – Pankaj Pathak, Fund Manager – Fixed Income at [email protected].
For all other queries, please contact Neeraj Kotian – Area Manager, Quantum AMC at [email protected] / [email protected] or call him on Tel: 9833289034
Read our last few Debt Market Observer write-ups -
- The Inflation Tantrum
- The Bond Shakeout
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