In a surprising turn of events, RBI / MPC made an intermeeting decision to hike repo rate by 40 bps and CRR by 50 bps. Though since the April policy market has been pricing for a faster normalisation (interest rate swaps had been factoring in front loaded normalisation and cumulative hikes of 275 bps over 2 years), almost no one at all was prepared for an intermeeting action.
The Governor positioned this as a reversal of the intermeeting 40 bps cut undertaken on 22nd May 2020 and thus in keeping with the announced stance of withdrawal of accommodation as per April 2022 policy.
The evolution of RBI assessment since February now constitutes a full about turn. This is somewhat understandable given the extraordinary events that have since transpired. The intense geopolitical escalations have put massive upward pressure on a host of commodities, thereby throwing expected inflation trajectories into chaos. RBI itself had to considerably revise its expected trajectory, increasing it by 120 bps to 5.7% for FY 23 in the April policy.
Even this itself was considerably lower (50 – 100 bps lower) than most private sector forecasts. Since then we have already had one nasty inflation print and concurrent commentary around a host of primary commodities continues to provide little comfort for now. In such a scenario it makes abundant sense for RBI to continue to be proactive in policy normalisation.
It will be recalled that it started over the latter half of last year by suspending outright bond purchases, followed it up with the VRRR tool that set the effective liquidity deployment average rate for banks higher, started to actively and passively pursue balance sheet reduction (largely via forex and some amount of outright bond sale), and then introduced the SDF facility that effectively created a floor for overnight rates 40 bps higher than the reverse repo.
These have now been extended with a 40 bps repo rate hike and 50 bps CRR hike.
Given a very different underlying aggregate wage and consumption dynamics as compared with many developed markets, alongside a relatively measured total fiscal and monetary response since the start of the pandemic, this does paint a narrative of a central bank quite in command in terms of actual actions (never mind previous assessment and forward guidance: more on this later) and undeserving of the ‘behind the curve’ tag that many have chased it with. When looked at cumulatively, and backed with now a firm eye on evolving inflation dynamics, RBI actually comes across as a very ‘on-ball’ central bank, especially when measured against some of its developed market counterparts.
Till very recently, the general impression of the central bank’s local macro-economic articulation was of growth momentum slowing and inflation being largely driven by supply side factors. These factors were largely expected to abate thereby leading to a substantial fall off in inflation towards second half of next financial year. Then the Russia -Ukraine war broke out and, with new and intense pressures arising from supply side, the inflation trajectory had to be revised sharply higher thereby robbing RBI of the space it thought it had earlier to continue to support growth. This made it necessary to hasten the process of normalisation as listed above. The fact that this entailed ‘going back’ on previous ‘assurances’ (orderly evolution of yield curve being one) can also be understood since we are now in midst of events that one couldn’t possibly have predicted.
The issue, however, is somewhat different: One of the very potent tool that a central bank uses is guiding the transmission to markets of its expected policy direction. Thus even before the central bank moves fully in the desired direction, market forces are already doing their work for it since they are forward looking in nature. One example of this is that of the US currently, where market yield curves have already risen in line with a view of terminal Fed funds rate of in excess of 3 per cent, even as the said rates are barely off the ground at the time of writing. This has caused the process of tightening of financial conditions to be well and truly underway (US mortgage rates have risen by approximately 225 bps just since the start of this calendar year and there are at least early indications that, alongside the spectacular rise in house prices, this may be starting to weigh on housing demand).
To be fair, the transmission of market rates into lenders’ offered rates is nowhere as seamless in India (lending rates are only being nudged up even as market yields have moved up substantially). Nevertheless, the principle is the same and is at least equally applicable to market interest rates where a sizeable amount of business by economic agents gets conducted.
Now while the normalisation process now undertaken by RBI is fully understandable as discussed above, what is somewhat more perplexing is its somewhat of a disregard to the forward pricing mechanism of the market. Thus even after discounting 275 bps of cumulative rate hikes over 2 years, swap yields have nevertheless risen another 50-60 bps today.
Thus the market is now expecting the terminal effective overnight rate in next 2 years to be either 1> around 7% or more, or 2> or if lower then much faster rate hikes over the next one year. This leads us to one of two possible conclusions: One, RBI is not looking at market pricing. If true then this should be rectified since the system is then bearing an avoidable higher cost from policy normalisation. Two, RBI is aware but is comfortable with this pricing. If this is true then it becomes very hard to justify its general economic narrative (even accounting for the new supply shock). It is then an issue of monetary policy being called upon to do active and substantial demand management, and not just addressing the possible second round effects from what is inherently a supply side shock in an otherwise a relatively ‘well behaved’ demand environment.
Staying on the subject, if there is relative sensitivity to market pricing then one cannot help but count some misses in communication as well. For one, introducing this very unwieldy concept of ‘real’ policy rates has further fed the market’s forward discounting panic. In a supply shock environment, headline inflation is bound to go up as is the case now. In a market where inflation expectations don’t get actively traded and thus one has to only rely on surveyed expectations, it becomes quite difficult to communicate consistently using this tool. Thus it has been variously understood as policy rates above 4 per cent (mid-point of target) from the dovish crowd (thinning out by the minute, admittedly) to rates above 1 year forecasted inflation (anywhere 5.7 per cent onwards).
As another example, the reference today to 40 bps hike being seen “as a reversal of the rate action of May 22, 2020 in keeping with the announced stance of withdrawal of accommodation set out in April 2022” potentially opens up another 04-May-22 source of confusion. This is because as the Governor’s statement notes “in response to the pandemic, monetary policy had shifted gears to an ultra-accommodative mode, with a large reduction of 75 basis points in the policy repo rate on March 27, 2020 followed by another reduction of 40 basis points on May 22, 2020”.
So does this now mean that RBI /MPC can go ahead and hike another 75 bps anytime at all and still characterise themselves as still being in the process of withdrawal of accommodation? While strictly speaking they may be correct (guidance on liquidity withdrawal is clear that it will be a multi-year process), this still serves as one more trigger for confusing market expectations; ironically probably having the exact reverse effect of what the statement may have intended to achieve.
If our list of ‘misses’ above seems longer, then there is a reason. Starting off, it needs to be read in the right spirit: that of an analytical point of view with the full realisation that the counterpoint may be equally strong. In turn our analytical point of view has been expressed in our market views and portfolio positioning, and these will take a square blow to the chin today. We turn now to a more detailed analysis of these.
We had assessed in our last note that we are in the endgame of rate hike pricing (https://idfcmf.com/article/7676 ). This had three takeaways in our view: One, there is a world of difference between actual central bank action and what the forward pricing mechanism of markets discounts. We had further concluded that swap pricing seemed excessive given our underlying views on the cycle. Two, we had cautioned that markets had a tendency to overshoot and the objective of flagging the endgame therefore was that while expecting volatility over the next few months investors should still start scaling into medium duration bonds with a sufficiently long investment horizon, rather than looking away from these. This was especially true after factoring in the carry buffer owing to steepness of curve.
Three, we had made the case for 4-5 year segment basis the steepness of this segment over 2 year yields and our assessment that while rate hike pricing may be nearing a top, bond supply premium isn’t since the supply calendar has only started. Thus, longer duration bonds (10 year and beyond) didn’t appear as efficient ways to play curve steepness, given the added duration risk that they posed.
A stark assessment of this framework basis today’s developments seems to render it on shaky grounds. Thus swap yields have put on another 50 bps as observed earlier and, although we can hide behind our observation that we flagged volatility over this last phase of repricing, that would be an unjustifiable and a pathetically transparent cover. Instead we must admit that we never expected this large a volatility over this short a timeframe. While we have noted that one needs to have sufficiently long investment horizons to benefit from the steepness protection calculation, it is also true that the 30-45 bps rise in bond yields today in the 4-5 year segment has taken out something like 6-8 months’ of carry buffer.
Finally, the spread to 10 year of our preferred segment (4-5 years) has further compressed over this move.
The above said (and with the words “you won’t get no bellyache from eating humble pie” firmly echoing in our ears) we find no reason to drop the framework. The essence of the issue, as analysed in detail above, is a rapid re-assessment of market’s expected rate hike cycle without an equally material change in the characterisation of the underlying macroeconomic cycle.
Thus while the pace of normalisation being undertaken is swifter than earlier envisaged we believe the market’s extrapolation of the same, while understandable, is probably incorrect. In other words this means a quicker journey to a somewhat neutral setting but much more reluctance beyond that as compared with what the market is currently pricing. The risk in the meanwhile remains that, unless RBI actively recognises the unnecessary costs currently being borne from the normalisation cycle and actively moves to address the forward pricing mechanism, market will remain confused with respect to what to price in as terminal rates in this cycle.
However, we expect this confusion to start to get resolved later in the year as more visible signs of growth slowdown emerge with consequent lesser fears of second round effects of inflation. Thus, and notwithstanding the setback today, we continue to think that 4-5 year sovereign bonds provide very decent duration risk adjusted return for a medium term horizon, and that investors should continue scaling into this segment over the next few months for those relevant investment horizons.
(The author, Suyash Choudhary is Head – Fixed Income, IDFC AMC)