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SUYASH CHOUDHARY
HEAD – FIXED INCOME Awaiting RBI : A Bond Update
Risk Management : A Macro and Bond Update

We had written recently (https://idfcmf.com/article/6269 ) on the somewhat worrying inflation dynamics that have been
evolving, particularly in the US where the global supply dynamic is meeting an unprecedented demand stimulus. Our
concern is with respect to the extent of disequilibrium between actual data prints and the Fed’s expectation and the
current policy stance (still growing balance sheet and still at effective zero). At least for the time being, the balance of
evidence seems to be concretely shifting against “Team Transitory”. Thus even as there is some mixed anecdotes lately
on some supply chain decongestions, pricing pressures with companies (both prices received and prices paid indices in
surveys are on a tear) and labor market tightness is all too evident. Further, growth seems to be rebounding after a
slowdown in the last quarter as is evident in both nowcast indices as well as in the skew of data surprises. Even the
commentary around Chinese policy measures seems to be one of incremental easing to now try and stabilize the property
sector. Partly reflecting this there seems to be some life returning to the metals space . It is to be recalled that the Chinese
slowdown thus far has been an important counterbalance to the massive growth stimulus in the developed world, led by
the US. Finally this latest coordinated release of strategic petroleum reserves by consuming nation s can be looked at as
the proverbial glass half empty as well: to the extent that OPEC takes umbrage at this and adjusts future production, it
may actually turn out to be counterproductive. The initial post announcement spike in oil prices certainly seems to suggest
this line of thinking.

To be clear, the argument against the idea of transitory inflation isn’t that the current levels of inflation will persist (US
CPI was 6.2% in October). It is quite obvious that the data prints today are in the realm of drama and won’t sustain for
long, both as the base effects come into play and as some of the extreme supply congestions in evidence today smoothen
out (both owing to logistic smoothening and producer response to prices). Rather the extent and duration of deviation
now seems to stretching the boundaries of transitory (ultimately everything is transitory). More importantly, other
avenues of inflation like labor market tightness and housing may prove to be more durable. The 5 year market US inflation
expectation in excess of 3% today seems to be telling as much and has climbed rapidly from somewhere around 2.5% as
recently as early October. Thus even as inflation is expected to start to fall as some of the effects mentioned above fade,
it is still likely to be stickier at above previous trend for a while.

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Managing Risks

In a scenario like this, and irrespective of one’s views and biases, risk management becomes of paramount importance.
The US Fed has thus far anchored its thought around the labor market as it existed in February 2020. But what if, as more
and more observers are opining, the labor market is undergoing a change? What if the phenomenon described as ‘The
Great Resignation’ (people opting out of labor force, taking longer breaks, shifting to jobs w ith better payoffs / benefits)
has room to run? This would mean that the labor market tightens much sooner than the Fed thought till very recently
with consequent impact on the path of policy normalization. Already doubts have crept as, for instance, evidenced in
the Fed Chair’s recent observation about labor supply not picking up post expiry of benefits in September. There is also
more reference to humility and yet, in our view, a good opportunity to display both humility and risk management was
passed over in the last Fed meeting by not deciding upon a more aggressive path for taper. This is expected to get
rectified in the next policy meeting, and market is even bringing forward the expectation of the first rate hike towards mid
of 2022. Front end yields have aggressively spiked consistent with the new expectations, with the 2 year US government
bond yield practically doubling since early October.

RBI is in a much better place. Not only has India’s fiscal response been measured, but RBI has already started the process
of policy normalization; first by stepping away from active government bond yield support and now through stepping up
the quantum under the so-called variable rate reverse repo (VRRR) auctions. The bulk of headline system liquidity is now
earning very close to the repo rate for banks under these VRRR. Thus while the marginal rate on overnight is still at
3.35%, the average is now much higher than that. In some sense then the central bank has already prepared the market
for the normalization of the repo – reverse repo corridor in the time ahead. To be clear, when this happens (when the
marginal rate moves up as well) there will still likely be an impact on the market, especially in money market rates.
However, the VRRR schedule has well and truly begun the transition to such a regime. Again, as far as market expectation
as per the swap curve is concerned, there seems to be close to full pricing of the path of policy normalization ahead.

Why Worry?

A relevant question to ask is this: if yield curves are already so steep and if market is already pricing in a substantial
normalization cycle (both for the Fed and RBI) then why should portfolio managers worry? Isn’t everything, so to speak,
already in the price? The following points merit consideration, in our view:

1. When we are very far from equilibrium, the potential for chaos is higher. Remember US matters since it is in
some sense the custodian for financial conditions in emerging markets. That is to say we can ignore US tightening
to some extent, but it is hard to argue for complete insulation. The argument to ignore US would have been
stronger if in fact India’s own inflation dynamics were very comfortable. However, even as RBI is better placed
as discussed above, inflation pressures are rising in India as well compared with what one thought just a month
or so back. Thus the recent rise in food prices, along with telecom tariff hikes, have more than completely
neutralized the duty cuts on petro products. CPI is set to rise to beyond 5% in the ne xt reading and then to 6% or
beyond subsequently for the next few months. Commentary from companies suggests continued product price
pass throughs as the substantial pick up in economic activity is now underway. The risk to bonds here is not so
much from a more aggressive rate hike schedule (a lot seems priced in as discussed) but more from what
approach the RBI will take towards liquidity management. There is already commentary around wanting to
reduce the current level of heavily excess liquidity towards a regime where the productive needs of the economy
are met. What is not clear is whether the voluntary longer term VRRRs will be deemed to be sufficient liquidity
measures, or whether more permanent measures like CRR hike and / or MSS issuances will be deployed as well?
CRR will of course have a strong signaling effect as well whereas even MSS bonds will constitute incremental
supply of carry assets to the market

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 2. While the yield curve is steep, bond valuations versus recent few months haven’t really cheapened appreciably.
This statement needs some qualifications. Rates at front end have risen somewhat whereas the 10 year yield had
also started to adjust higher (the latter on discontinuation of bond purchases from RBI). These developments are
in line with our bond framework expectations where we have expected most of the flattening to happen in the 1
– 5 years space rather than 5 – 10 years. This has informed our preference for the 5 year point. So while the innate
protection at the 5 year point is well understood, the level there itself has pretty much been in a range while
global and local inflation drivers have strengthened and expectations on policy normalization have accelerated.
Further, our swap curve has dutifully responded to these developments thereby compressing bond-swap further.
Thus the decision to create flexibility against potential chaos is that much easier given largely range bound bonds.
While there’s prospective foreign bond demand ahead on bond index inclusion, it is too early to play that now
in our view. For one, one doesn’t know what the global environment will look like when that news is more
imminent. If we are in the midst of an accelerated Fed normalization then the bond index inclusion news, while
incrementally positive then, may hold no relevance versus where valuations are today. Further, RBI is now
largely out of the picture and as we have opined before, it may just happen that foreign money fills in some of the
void left by RBI’s bond interventions. Finally, as the swap curve has shown recently, what may look like fair
pricing on an excel sheet can nevertheless get substantially overshot if the environment turns relatively hostile.

Conclusion

The other way to think of the above analysis is in terms of the cushions available when opting for more flexibility now.
That is to say, it is very unlikely that one loses much more than just carry since any fall in yields is expected to be tempo rary
at best. Reflecting all of this, we have further increased cash and near cash levels in our actively managed bond and gilt
funds to approximately 60 – 70% as at 23rd November 2021. We continue to find more value in bar-belling (or simply
put cash plus bond strategy) to guard against potential volatility, rather than using swaps where the pricing isn’t as
compulsive anymore as a hedge given what is already priced in that curve.

A point made before, but worth highlighting again, is this: the concept of portfolio yield is relevant in a steady state
scenario when the prospects of actually making that yield are strong. However, when the environment is in flux as it is
now in our view, one has to focus more on the concept of holding period return (HPR). Active management, if it helps
optimize HPR by reducing impact of volatility, should hence be welcomed even if it leads to a temporary fall in portfolio
yields. Of course, active management can bleed value as well if the view goes wrong but that prospect isn’t sufficient
argument to not do anything if one’s reading of the environment is changing.

Again, what has been presented here reflects our current thinking. As always this can change at any point in time.

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24-Nov-21