Is RBI behind the Yield Curve ?

Caution and prudence are the hallmarks of any Central Bank . RBI is no different and is rightfully hawkish on interest rates . However , sometimes , too much of prudence can hurt growth . As someone wise said ,  timid drivers are as risky in motorways as reckless ones . Striking a trade off could be a tricky one  . But the bond market is in no mood to be patient for the RBI cues and seems to be drawing its lines already  . With bond market rallying sharply over last few weeks ( Gsec yields falling as a result) , RBI is at the risk of falling behind the yield curve , if it continues with its hawkish tone for  an extended period .

With ample evidence  across the spectrum for a benign inflationary outlook , the reasons for holding on to hawkish stance are receding rapidly for RBI . Lack of progress on subsidy reforms  , policy paralysis and farmer-friendly inflationary policies can no longer be sighted as excuses now  with the new govt.  acting swiftly on these concerns . Diesel deregulation , Labor reforms , slow down in NREGA spending , Gas price finalization , Coal Ordinance ( privatization of coal mining ) , Easing of foreign investment in construction sector  and broad-basing direct benefit transfer for LPG are some of the key  measures unveiled by the Govt. to boost its reformist credentials.  Even the merit of having high interest rates to face the liquidity crisis in the event of Fed rate hike cycle does not stand to reason now with the new liquidity window opening from east  ( recent quantitative easing by Japan Central Bank) to offset any such outflows . Add to this , the struggling industrial growth ( capex woes) and ample liquidity in the banking system ( with credit growth failing to take off )  , the case for cutting rates has never been stronger .  Not surprisingly ,  the industry captains have joined the chorus ,  putting further pressure on RBI , leave alone the not-so-tacit nudging from Finance Ministry . More of a whisper so far , it can slowly turn into a scream from these quarters . More so with the  CPI inflation data coming near 5.52% for month of Oct .  Time is right for RBI to take a bold gamble.

Let us start with what caused the rally in the bond market .  At the root of this rally lies the rising optimism of India Story . It may be a “goldilocks” moment  for India . Favorable global factors like falling crude , rising liquidity , moderating commodity prices etc coupled with changing domestic economic landscape in terms of falling twin deficits , bolder reform actions  , benign demand outlook etc  have all come together as a crucial combination  to conspire a smart turnaround to make India as one of the few shining spots in the global map. Such a powerful optimism has fueled a surge in inflows into Indian debt market (both corporate bond and Gsec markets ) this year . With $ 22 Bn inflows (as on Oct end) and still counting , debt has attracted twice the amount of equity flows in this calendar year . Strong flows into debt markets have boosted demand for Gsec papers and thus lowering the yield  .  Further , the significance of the sharp fall in global oil prices ( near 25% crack) can’t be brushed aside , even if the hawkish RBI may wish to do in the name of the prudence and glide path inflation targeting (  6% CPI target by end of FY16)   . Every 10$ fall in oil prices has the potential to shave off near 50 bps from both WPI inflation    , leave alone the positive impact on the fiscal and current account deficits .

Bond market in its wisdom has understood the relevance and significance of these developments on the inflation and hence the interest rate outlook  . By rallying by over 40 bps over last few weeks , it has set its sights on 8% level for the Gsecs . Will RBI take the cues from the bond market and cut the benchmark repo rates in its upcoming monetary policy meeting ( scheduled on 2nd Dec ) or will it risk  falling  behind the yield curve by delaying the rate cuts . As they say , the luck favors the brave and it is time for RBI to take an unconventional one.

Market View :

Last few months have been tricky for fund managers . On one side , there is a growing view that the market is running ahead of fundamentals with its expensive valuations . On the other hand , confluence of factors such as falling crude , stable currency , improving macro , surging global liquidity etc. have come together miraculously  to push India’s potential growth rates to a higher trajectory in the coming years , certainly from  FY17 onwards if not in FY16 itself . Government , not to be left behind , has been keen to capitalize on these favorable turns . If the cabinet rejig and secretarial shuffle ( in Finance Ministry) are anything to go by , upcoming Budget should set the tone for a bold reform agenda . It does not stop there . If RBI takes the cues from the bond market from  falling Gsec yield ( & from falling inflation data)  and start cutting benchmark repo rates , that will bring added cheer to the rising optimism .  In such a situation , market starts ignoring the short-term disappointments in data points like the muted monthly auto numbers  etc and start looking far ahead . That is how typical bull market behaves .

For fund managers , finding value in this market is increasingly a challenge  .  It has  not been easy for investors either . Having waited  for an elusive correction for long , they are being now forced to enter  at higher valuations , if the surge in domestic money flows is anything to go by  . At Rs 3,877 Bn and still counting  , net flows into equity schemes in the first seven months of 2014-15 have already exceeded those in all previous years, except the Rs 4,700 Bn during 2007-08, the year when the previous bull market was at its peak. This is a record number for domestic flows .

With benchmark indices at new highs , it is not time for adventure certainly . At the same time , sharp corrections can remain elusive for an extended time given the current bullish undertones , though it can’t be ruled out . In such a scenario , choosing a mid-way is not a bad-way . On a two to three year perspective , Investors will do fine with bottom up stock picking on mild corrections whenever valuations turn reasonable , without waiting for a sharp correction , yet  keeping some cushion (cash) for the rainy day  .

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In an ironical twist , global cues ( leaving out the latest Japanese stimulus ) have begun to worsen precisely when prospects for ground-up reforms have brightened in India . Much of first four months of the new Govt. had passed in high decibel rhetoric , though it was a refreshing change from the sulking silence of the previous Govt. . As much it was required for initial sentiment boosting , carried too far , it would have tired even the most vocal supporters of this government . Much to the relief of many such hopefuls , Govt. got into action quickly after the state polls without losing too much time . Diesel deregulation , Labor reforms , Gas price finalization , Coal Ordinance ( privatization of coal mining ) , Easing of foreign investment in construction sector and broad-basing direct benefit transfer for LPG are some of the key measures unveiled by the Govt. to boost its reformist credentials . Coming on the back of worsening global macro , these measures assume significance for India to stand out in this global turbulence.

Up in the sky , dark clouds have gathered over global macro . Slowing China , fears of recession in Europe , volatile data points from US , cracking Crude , Fed fears ( of interest rate hikes) etc. have cast a spell in global markets . Falling US treasury yields and rising dollar index reflect rising worries on global growth . US treasuries have firmed up in the last few weeks ( as a result yields have fallen as much) . There is a worrying wobble across equity markets. Most of the emerging market equities are sharply down . Ride has been even more rocky for EM ( emerging markets) currencies . Much of the EM currencies are down by over 10-11%+ . Even equities in mature markets are down over 5% over last two weeks . Amid this global turbulence , it is heads-up for India . In a rare instance of resilience , Indian equities as well Rupee have remarkably withstood the global heat .

Much of the credit for this rare moment should go to India’s growing “political currency” after stunning election results that brought a stronger and stable governance to the country . Strong flows into debt markets even amid global turmoil in a way reflect growing confidence on the Indian political administration . Besides , India is blessed uniquely to gain from the worsening global macro via sharply lower commodity prices and thereby boosting its prospects for lower import bill and for sharply lower subsidies . Sharp fall in global oil prices ( near 25% crack) has come as a boon to India . Every 10$ fall in oil prices has the potential to shave off near 50 bps from both WPI inflation and from current account deficit . That is the significance of falling oil for India macro. This coupled with stronger growth outlook on rising domestic consumption have the potential to put India as a shining spot on a weakening global map . It can sparkle as the silver-line in the darkening clouds.

From this backdrop , any correction in Indian markets will be a great opportunity for investors to build new positions . As many global investor concur now , India Story is back with a renewed vigor now and is here to stay . If shuffling of secretaries in Finance Ministry and the appointment of new Economic Advisor are anything to go by , the signs are clear that the coming budget will build the foundation for structural reforms . Any correction should be seen as a golden opportunity from this perspective .Watch out for interesting times .

ArunaGiri . N