India 10Y benchmark 8.40% 2024 is firm (and steady) at 8.35-8.40% despite fireworks (and excessive volatility) in US 10Y yield at 1.90-2.65%; in the process bond spread has moved back-and-forth of 5.85-6.35% tolerance zone, seen as ideal range to support Rupee stability at 60-62 by retaining FII appetite on India MM assets as alternate to equity. What is the way forward.
The factors (and cues) in support of decline in Bond yields (and Money Market rates) are many! yield/rate curve across short to long term is flat in expectation of shift to dovish monetary policy stance; borrower's demand for funds is in the shorter end while investor's supply is in the longer end, thus squeezing the tenor premium to zero (with 1-5 year Rupee IRS curve at deep discount by 40 bps); cause of concern (and worry) from twin deficits and its adverse impact on inflation and Rupee are no more relevant. Then, why delay the inevitable?
RBI's worry is from the sustainability of retail inflation at lower end of 6-8% target zone (and WPI stability at 2-4%) when benefits from external cues are seen to be fully done?! The risks as seen by RBI from external sector is from possible recovery in commodity prices and aggressive rate hikes from the FED. On the domestic side, worry is from possible lag time to build supply-capacity to meet demand-expansion and lack of muscle power (and deep pockets) to protect Rupee against squeeze in interest rate differential between Rupee and the dollar. Given the limited traction between interest & growth rate, RBI see prudence in retaining extended pause till structural woes on Rupee (from CAD and high dependency on hot-money inflows) and supply-side bottlenecks (from capacity expansion) are resolved to its satisfaction (and comfort). Till then, intent of RBI is to retain 8.5-9% as overnight Rupee supply/refinance rate from RBI counters, through administration of deficit system liquidity. RBI has the support of IMF in validation of its stance to stay neutral on rate direction, and that the rate direction (up or down) to be set by inflation expectation and interest rate differential (and not turn it around as support to consumption/growth and to disincentivise savings).
RBI has two options: (a) cut policy rates by 50 bps with status-quo on liquidity administration policy to allow consolidation in overnight rate at higher end of 7.5-8.5% LAF-MSF corridor; (b) refrain from pumping out excess system liquidity to allow ease in overnight rate into 7%, lower end of LAF corridor, without the need to cut policy rates. The third option of extended pause (taking wait-and-watch stance) may not stay for long given the pressure from most stake-holders! RBI agenda is the balancing act to retain interest rate supportive to growth/consumption & savings and Rupee exchange rate. It is obvious that the stance can not be extremes and the policy stance has to be somewhere in the mid-path, without losing balance either-way!
What is the way forward? 10Y benchmark yield at 8.35-8.40% is at mid-point of short term best case scenario of 8.15-8.20% and worst case of 8.60-8.65%. While the pull is towards 8.15%, the risk of push into 8.65% is also high on any weak data, external headwinds and supply expansion-demand squeeze market dynamics. All taken, while there is great confidence in retaining the set strategic focus at 8.15-8.65%, cues are not clear to suggest directional bias while at 8.35-8.40%.
What should investors do? When it is risk-neutral, it is prudent to stay light either-way! It is also certain that extended gains into 8.15% is surely in the making; doubt is from either 8.35-8.40% to 8.15% or post some more sideways play at 8.30/8.35-8.45/8.50%. Given this expectation, it makes sense to stay light on the "long" side with good appetite to add on weakness into 8.40-8.50%.
Moses Harding
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