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  • Saurabh Bhatia

    Head of Fixed Income, DSP Investment Managers
    Bhatia has over 16 years of experience on the fixed income side and joined DSP Investment Managers in July 2017 as Vice President in Fixed Income Team. Prior to joining DSP, he has hand stints with ICICI Bank , HSBC Asset Management, Sahara India Financial Corporation, Tower Capital and Securities and Chandrakala Money and Capital Management.

Growth-focused rate cycle throwing up opportunities in bonds, debt funds

Markets wanted rate cuts, easy liquidity, strong political mandate, and a good monsoon.

ET CONTRIBUTORS|
Updated: Oct 08, 2019, 02.26 PM IST
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In older times, when the two-stroke (Bajaj!) scooter would not start, it needed to be tilted a little and it would quickly get up and running. Similarly, if the grand old Premier Padmini refuses to move, keep the bonnet open; give it some fresh air, a little push and it would soon be up and running.

We got used to relate growth revival with a similar case; cut rates, provide liquidity, add some political stability, pray to rain gods (they have been generous) and growth is up and running.

Flashback six months – markets wanted rate cuts, easy liquidity, strong political mandate and a good monsoon. While we got most of these things, rather a lot more than what we had asked for, why does the slowdown seem so stubborn?

Over the last two decades, global downturns have been largely driven by key events: Slowdown triggered by 9/11 World Trade centre attacks in 2001, Global Financial Crisis in 2008 and Taper Tantrum in 2013, which was characterised by synchronised efforts by global central banks and policy makers. The current phase of slowdown in global growth is driven largely by an escalation of trade war in the backdrop of protectionism. This indeed makes it difficult to scratch the bottom of the cycle as the beginning of the end is unknown.

With no end seen to the escalation in trade war, we expect conventional rate actions to have lesser bearing on the prospects of growth revival, as the economic environment remains less conducive to pass on the mantle from public investment to private investment.

We are made to see through events as visibility remains poor. Few months back, uncertainty persisted as the market waited for the domestic election outcome to pave the way ahead. Few months from now, the market will watch out / wait for the outcome of US presidential elections, implying ‘uncertainty’ will prevail for a sustained period.

Uncertainty is detrimental to growth momentum, and lower growth momentum negates upside risks to inflation. Interest rates will remain benign till this combination is at play.

Confining ourselves to the Indian economy, we take solace from two critical factors: first, India is blessed with a strong political mandate, a critical enabler to attract riskier capital as and when it finds opportunity to move, and secondly the intent of the government to abstain from inducing fast-tracked growth via higher subsidies, direct benefit transfer, etc.

In the runup to the announcements of corporate tax cut, we were envisaging the cost of money to come down and stay low amidst stable macros. We have notched down this view for the cost of money to come down while ability of cost of money to stay low will depend on the extent of rise in government borrowings, which the recent announcement can induce. This action from the government can seed riskier capital in the hands of corporates rather than induce / fuel consumption on an overnight basis.

Nonetheless, as the corporate tax cut does not have a direct impact on growth and inflation, we expect the interest rate trajectory to remain benign. In this backdrop, we attempt to identify various phases of the interest rate cycle and plot the way ahead.

Scenario 1

Growth turnaround can materialise through a fiscal-fed fast-tracked growth. This type of growth turnaround reflects higher fiscal deficit (hence, higher interest rates), higher CAD (hence, weaker pressure on the currency), which then stoke inflation. Herein, RBI tends to maintain tight liquidity conditions to wear off imminent inflationary pressures. This model of growth decreases the economy’s immunity, making it more vulnerable to global shocks.

A fiscal stimulus to drive consumption can lean towards Scenario 1 as mentioned above and revisit the problem of 2009–2013. It must be noted that revenue expenditure constitutes close to 90% of total expenditure, and unless we improve the quality of fiscal deficit, any misadventure on the fiscal front (for fast-tracked growth) may disturb the applecart and negate RBI’s rate cuts.

Scenario 2

On the other hand, growth can also be realised by keeping macro-stability intact; as a disciplined fiscal approach can help to keep interest rates benign and allow RBI to maintain easier liquidity. This model seeds sustainable growth momentum and, more importantly, allows the mantle to be passed from public investment to private investments. Moving from Scenario 1 to Scenario 2 is indeed painful, as we undo the past excesses to pave the path for sustainable growth cycle.

Longer this intermediate phase lasts, deeper we endure a pain that seems inevitable. Hence, instead of a wide talk of fiscal stimulus to reboot the economy via consumption, a dose of savings stimulus will do a world of good, as the same can be directed towards infrastructure growth, which can help address a variety of problems, including dearth of jobs and weaker rural wages.

Repeat of RBI bonds (savings bonds) issued in first half of last decade can be of great help in this regard. A move from Scenario 1 to 2 is typically characterised by the problem of cost of money as well as availability of money; a phase we were in from September to December, 2018. This phase begins with easing of the cost of money as evidenced in RBI rate cuts since February, followed by intermediate liquidity infusion and eventually addressing the problem of availability of money.

The intermediate phase can be pretty long, as it can widen the difference between haves and have not’s in the context of liquidity. We are in this intermediate phase, wherein banks are flushed with liquidity and a large part of industry is grappling for liquidity.

Hence, on one hand banks sitting on high liquidity for a prolonged period may feel the pinch of lower earnings as their excess cash does not yield much. On the other hand; corporates, financial institutions that continue to struggle to refinance/recapitalise tend to lose sheen (equity). A few end up consolidating while a few others may risk falling off the cliff. As this heap of ‘grey’ becomes ‘black or white’ through this phase, riskier capital, which is a lot cheaper now, starts making inroads into the economy, thereby solving the problem of availability of money and marking the beginning of growth cycle.

Recipe for growth = 135 bps rate cut + accommodative stance “as long as it is necessary to revive growth.”

With the recent rate cut accompanied with a sharp downward revision of growth by 80 bps from 6.9 per cent to 6.1 per cent for FY2019-20, the loud and clear message from RBI was to maintain an accommodative stance “as long as it is necessary to revive growth.”

RBI’s ability to fire more bullets (repo rate cuts) with the same consistency would appear to diminish until cost of money in the system starts to correspond to the extent of RBI moves. This was again evidenced in the market yields remaining stubborn at elevated spreads, despite a repo rate cut accompanied by very dovish tone. Unless sovereign yields get closer to the repo rate; a reduction in cost of money for the economy will take a little longer to achieve the desired goal of monetary transmission, which has so far remained “staggered and incomplete.”

Repo rate and market yield

Amidst this benign interest rate regime, determinants for repo rates and market yields are different, resulting in these two segments not moving in tandem. Repo rate ‘cruising’ lower is largely driven by benign outlook on inflation and growth while market yields are largely driven by demand and supply of bonds. For those seeing this as ‘glass half-empty,’ it shouldn’t surprise when repo rate plateaus and yields start responding to the favourable demand-supply equation.

With the fear lingering on the extent of increase in government borrowings, the demand – supply equation for bonds, particularly for this quarter, remains skewed in favour of supply, implying pressure on market yields. The key spender in the economy, i.e. the government, will also rely a lot on borrowing through this quarter, as advance tax collections will remain considerably lower post the recently announced tax cuts.

Redemptions, prospects of open market operations and government borrowing calendar ending in late January (as per recently-released borrowing calendar) creates scope for yields to come down post the highs that we’ll test this quarter. October, with fewer working days, will test the ability of the market to absorb the weekly auctions (Centre + state), implying pressure on yields.

Hence, despite lower repo rate, market yields determined by demand and supply will witness higher volatility through the next two months due to skewed supply. That said, the skewedness of supply on bonds will reduce into the last quarter, enabling yields to head lower towards the end of this financial year.

In the near term, the recent uptick in food inflation may keep CPI prints at higher bounds, aiding further volatility in bond prices. For, all the efforts of the government and RBI to bring down repo rate and enable risk appetite by reducing corporate taxes will turn futile unless sovereign yields come down. A rise in yields will provide an opportunity to add duration through this quarter. Risks to this view can rise if the government expands the fiscal space considerably for fast-tracked growth.

Opportunity

Indian bond markets are characterised by demand from end-investors. In times when credit growth is weak, appetite for corporate bond is weak and liquidity in hand is abundant. The end investor category tends to lean toward higher carrying, low credit risk asset even at the cost of some duration. With the nudge to adjust bank lending rates in lines with falling repo rates, banks’ lowering their MCLRs will find favour with the SDLs and high-yielding sovereign gilts trading closest to the lending rates. The yield curve has remained steep through this phase as evidenced in spreads between one-year Treasury Bill and 10-year sovereign yields, as well as spreads between five-year sovereign yield and 10-year sovereign yields. With the softening rate story still intact, we expect this form of steepness in yield curve to bear a shorter shelf life.

SDL supply tends to pick up through this phase and peak out in February-March, while supply of government securities tends to peak out earlier by a month or two in line with their respective borrowing calendar. Hence, post the realignment of yields during this quarter, we expect government securities, especially in the medium- and long-end segments to provide a favourable risk-reward.

For investors, who seek to remain immune from volatility, the high-rated short-end corporate bond segment will continue to find favour in times of easier liquidity conditions and benign interest rates.

The low-rated, high-yielding credit vertical requires a positive growth momentum and lower cost of money to turn good. With only one of the two requirements at play, this segment is expected to outperform with a lag.

With so much twists and turns amid lower visibility, it is recommended to apportion investments between the roll-down and open-ended category, basis investment horizon and appetite for volatility. This can help tick the right boxes – liquidity, predictability, returns and lower volatility - to meet return expectations on fixed income investments.
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
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