Easy liquidity despite tight RBI administration
Domestic Rupee liquidity is in administered regime with agenda to retain effective operating policy rate between Repo and MSF rate. Accordingly, restriction was imposed at availability of liquidity at overnight Repo counter with introduction of term Repo counter; all taken refinance window is now split across overnight Repo, term Repo and balance at MSF rate. Despite this tight liquidity administration, overnight call money rate remained around Repo rate with occasional pressure into higher end of 8-9% administered range. The reasons for this scenario (against RBI's agenda) is largely from lack of credit pick-up, risk aversion of lenders and excessive FC inflows diverted into the system through RBI dollar purchases. In the absence of demand from the Government, squeeze out of liquidity through bond issuance is muted. All taken, large chunk of bank deposits lie idle with RBI in the form of excess SLR against mandatory 22% of NDTL.
Gilts volatile on mixed cues
10Y Gilt has been volatile since July 2013; yield up from above 7% to over 9% (during July 2013 to August 2014). The weakness is from combination of domestic cues (inflation risks, rating downgrade fear and threat on Rupee) and global cues (FED threat of monetary tightening and risk of FII reverse flow). Since August 2014, most cues turned in favour; luck from external factors (sharp reversal in imported commodity prices, extended ultra-dovish monetary stance by BOE/ECB/BOJ/BOC, and FED patience on rate-hike shift) and hope from domestic cues (sharp reversal in inflation, signs of turnaround in macroeconomic fundamentals, shift in rating downgrade risk to upgrade optimism and pressure from most stake holders on RBI to cut rates) drove the 10Y yield down from over 9% to below 8%. It is great satisfaction to chase the new 10Y benchmark (8.40% 2024) both ways; got bulls-eye hit on the coupon at 8.40%, chased the weakness from 8.35% into 8.60-8.85% to switch sides for bullish chase below 8% into 7.75-8.0%. In the process, also chased the India-US bond spread from over 6.5% to 5.60% tracking the back-and-forth volatility in US 10Y Treasury yield at 1.90/2.0-3.0/3.10%.
Bullish consolidation in 2015
Domestic cues are mixed; RBI's concerns are from inflation stability within its comfort zone (CPI at 4-6% and WPI at 2-4%), structural risks on inflation from twin-deficits, low interest rate impact on Rupee exchange rate and permanent resolution to supply side bottlenecks. RBI is in wait-and-watch mode to see sustainability of base effect impact and commodity price support on inflation, resolution on fiscal prudence and achievement of demand-supply equilibrium before trigger of demand-push monetary support. It can be safely assumed that beneficial impact on the CAD from sharp reversal in Crude Oil price is there to stay through 2015; stability in twin-deficits at comfort zone of 2.0-4.0% will be relief for RBI to prepare for shift to accommodative, growth supportive monetary policy stance, and into lower end of said comfort zone will lead to shift of operating policy rate from Repo to Reverse Repo rate. The external cues largely depend on timing and extent of FED shift (and speed) into rate-hike mode and the extent of FII/FDI flows into the system.
All taken, it would be consolidation phase in H1/2015 for 10Y Gilt yield at 7.75/7.85-8.0/8.10% in traction with US 10Y Treasury yield at 2.0/2.10-2.25/2.35% with the spread of 5.50/5.60-5.85/5.95%. If FED shifts into rate-hike mode by mid 2015, it would be extended stability in H2/2015 subject to inflation stability at lower end of set comfort (and tolerance) zone; CPI stability at lower end of 4-6% will squeeze India-US 10Y bond spread to sub 5% for India 10Y bond stability at 7.75-8.0% despite spike in US 10Y Treasury yield over 3%. The downside risk for India 10Y bond is also from structural demand-supply dynamics, being not in favour against lower demand from the Government and excess SLR held by Banks (which will be used for incremental need or exit on improvement in credit risk appetite). There is also need to maintain India-US bond spread attractive for FII carry-trade play adjusting for 2-3% Rupee depreciation.
The investment strategy therefore is to play end-to-end by buying at 8.0-8.10% and staying light (or short) at 7.75-7.85% till we get better clarity from Budget 2015, FED monetary policy stance and trends in inflation and twin-deficits into 2015. The comfort is that there may not be repeat of prices volatility seen in 2013-2014 and would be tight range price-stability. It would be good opportunity for passive retail investors for yield pick-up over Bank liability/investment products, while aggressive investors shift focus to high-risk/high-reward equity assets.
Wish you all a profitable 2015!
Cheers!
Moses Harding
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