Sticky signals from Bond Market !!!

RBI’s Dilemma …

In a diverging trend, bond market (Gilts in particular) is signaling a sketchy outlook for rates. RBI’s rate action of 25 bps cut on March 19th had a diametrically opposite effect on the gilt rates, surprising even seasoned pundits in the debt markets. Ten year yield had softened to 7.8%   in the last week of Feb in anticipation of aggressive rate action by RBI in March policy meeting. But, yields started moving up post the budget and further hardened after the monetary policy action to close near 8.00% this week. This is a movement of 20 bps which effectively neutralizes the 25 bps cut by RBI. 

The reasons for such a divergence are not difficult to fathom. The initial trigger came from the negative surprise of larger borrowing programmes (relative to last year) from the Government. Market had expected a fall in the borrowing plans given the reduced fiscal deficit target of 4.8% (from 5.2%) in FY14. However, thanks to the rollover of earlier debts, the borrowing plans announced in the budget are much larger from the level of last year. What added to this was the unexpected hawkish tone of RBI in the March monetary policy meeting. “Even as the policy stance emphasizes addressing the growth risks, the headroom for further monetary easing remains quite limited” RBI had said in its guidance, citing the wedge between retail and wholesale inflation adversely affecting inflation expectations, besides high current account deficit.     

The underlying reason for RBI’s hawkish tone comes from widening dichotomy between the whole-sale inflation (WPI) and the retail inflation (CPI). While there is a visible softening in WPI on account of fall in prices in manufactured goods (core inflation) , the sticky outlook for food and fuel prices keep the CPI on the edge .  This diverging trend between WPI and CPI is on account of higher weight of food and fuel items in CPI (60 %+) in comparison with 30% weight of those items in WPI. RBI largely focuses its monetary action on WPI as core inflation (manufactured goods) responds to interest rates while non-core inflation (food and fuel) are largely insensitive to monetary tools (interest rate action). Non-core inflation is primarily supply driven and hence does not respond to monetary action.

In spite of this limitation, RBI in its wisdom feels that the aggressive cut in rates will reduce the real rates (interest rate adjusted for CPI inflation) and hence   will dis-incentivise savers in financial assets.  These fears are not completely untrue. Closer look at the impact of recent RBI rate cut on the final bank lending rates reaffirm the RBI’s concerns. None of the banks cut their lending rates (base rate) post the RBI action citing tight liquidity on account lower deposit growth. This is largely because of lower confidence in financial savings given the low or negative real rates (deposit rates adjusted for CPI). In glorified financial jargon, it means the transmission channel in the banking system is weak and hence rate cuts are unlikely to have a desired impact on the final lending rates. 

Of course, RBI has other tools like CRR (cash reserve ratio) and Open market auctions etc to infuse liquidity into the system. But overall its hands are tied given the sticky CPI inflation. Both bond market (Gilts) and Bank rates are signaling harder times for RBI (and the Govt) in navigating this tricky trade-off of pushing growth even as inflation (CPI) remains sticky. Since the crux of the problem is food and fuel inflation, RBI’s role is justifiably limited.

As supply side pressures require long-term solution, it may not be far-fetched to say that we are staring at a real possibility of stagflation in the short-to-medium term. RBI has smartly sensed this and has pushed the ball to the Govt’s court by summing up in its latest policy document as, “The foremost challenge for returning the economy to a high growth trajectory is to revive investment. A competitive interest rate is necessary for this, but not sufficient. Sufficiency conditions include bridging the supply constraints, staying the course on fiscal consolidation, both in terms of quantity and quality, and improving governance” .  Needless to say , it is a wake-up call for the Govt. !!!!

ArunaGiri. N.


Elusive Dawn !!!


Is the worst over ??

“Darkest hour is just before the dawn” is no ordinary  saying . Its soothing effect in a most depressive settings can’t be understated . However for India , law of diminishing returns has caught up with this phrase . Not without reasons , of course . India has seen many false dawns come and go , still awaiting that ever elusive real one.

After three successive years of anaemic  growth , forthcoming year (fiscal 13-14) may hold some promise for the upturn . With base effect kicking in along-with hope for reversal of interest rate cycle and recovery in investment cycle , chances of real dawn showing up have never been better . But nothing can be taken for granted given the precarious nature of twin deficits ( Fiscal and Current account) and the stubborn nature of the inflationary trend .

Sustained rate cuts are key to reviving growth ( esp in the investment demand) . RBI is keeping a tight lip while pundits have been busy pumping predictions on this . While inflation trajectory has started trending downwards ( as reflected in the latest WPI data) , the real comfort for RBI can only come from the quality of the fiscal adjustments that the  FM has  undertaken in his financial Budget . More than the headline fiscal deficit number , profile of expenditures hold the key for future rate cuts by RBI .  There are already murmurs in the Mint street that Govt. might fund its most ambitious ( and most populist )  food security bill  by cutting down plan expenditure ( capital investment outlays), while projecting a market friendly headline fiscal number  of sub 5% .  Such a Machiavellian approach might at best satisfy rating agencies , but risk inviting RBI’s ire . But political compulsions ( with elections not far away) might tempt the govt. to throw cautions to wind . 

The reasons for RBI’s discomfort on such approach are not difficult to fathom .  Diverting funds from plan allocation to social programmes will fuel  food inflation while hurting industrial growth and thus worsening already fragile inflationary trend . “If spending on social schemes comes at the expense of capital expenditure, it will be bad,” an official with direct knowledge of policy making told Reuters. “Inflation will go up, and there will be food inflation from the demand side.”

Given the high possibility that Govt. might risk RBI than the election prospects , it is highly probable that sustained rate cuts are sometime away . This means , RBI on its part will risk growth rather than inflation and hence will most likely take a pause after one or two more cuts of 25 bps . If that were to come true , we are , in all probabilities , looking at another year of slow growth esp. in investment / capex demand . That is not good news for investors who are hoping for the elusive recovery in capex . 

With one more year of pain ahead in capex and investment cycle , investors need to take that extra caution while investing in beaten down investment (IIP) stories !!!.

 Happy Value Investing !!!

 ArunaGiri . N