Mr. Suyash Choudhary
Head - Fixed Income

Bonds recovered from their June sell off while the curve marginally flattened as the 10-14 year compressed to the 5 year segment as market participants renewed their hopes on RBI intervention to ensure smooth transit of government borrowing program. RBI announced the new 10 year benchmark as the existing 10 year benchmark 5.79% 2030 reached an outstanding balance of Rs. 1.04 lakh crores. This was contrary to market expectations which was expecting the security to get auctioned for couple of more weeks given the higher auction sizes. As a result, the new 10y benchmark settled at a relatively lower premium of 7bps to the existing on expectations of smaller shelf life given the expected heavy supply from auctions and switches.

CPI inflation surprised sharply on the upside at 6.1% YoY in June v/s consensus of 5.3%. April & May readings were also released: readings of 7.2% in April & 6.3% in May. Core inflation rose to 5.1% (5% in May) owing to higher inflation in the personal care segment (12.4%) and in the transport and communication segment (7.1%). Higher gold prices along with the pass-through of the excise duty hikes on petrol and diesel were the major contributors to core inflation. Inflation across education, recreation and amusement, and health came in at 5.5%, 3%, and 4.2%, respectively. The government used a different methodology to arrive at the inflation estimates of April and May due to the non-availability of data due to the nationwide lockdown.

RBI released its Financial stability report in the context of contemporaneous issues relating to development and regulation of the financial sector. Macro stress tests for credit risk indicated that the GNPA (gross nonperforming asset) ratio of all SCBs (Scheduled Commercial Banks) may increase from 8.5% in Mar'20 to 12.5% by Mar'21 under the baseline scenario. If the macroeconomic environment worsens further, the ratio may escalate to 14.7% under very severe stress (whereas the system-level CRAR (capital to risk-weighted assets ratio) may fall from 14.6% in Mar'20 to 13.3% under baseline and to 11.8% under very severe stress scenarios by Mar'21). Among macroeconomic risks, risks to domestic growth and fiscal housekeeping were perceived to be 'very high', while risks on account of reversal/slowdown in capital flows, corporate sector vulnerabilities, real estate prices and household savings were perceived to be 'high'.

The US released its advance estimate of Q2 GDP which showed growth fell 32.9% q/q saar (seasonally adjusted annual rate), the largest decline in the history of the series. The decline was mostly driven by weakness in consumer spending reducing 25.1% from the GDP. The declines were mostly concentrated in pandemic hit sectors like transportation (-83.9% q/q saar), recreation (-93.5%), food services and accommodation (-81.2%) & in the healthcare component (-62.7%).

The FOMC policy meet was in line with expectations. The forward guidance was kept unchanged with the FOMC committing 'to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.' The Fed Chair emphasized that the pandemic is being viewed as a substantial 'disinflationary shock' & reiterated that the outlook will remain contingent on the manner in which the virus evolves. He further emphasized that rate hikes were not discussed and that policy will remain accommodative for a sustained period of time.

The monetary policy committee (MPC) on 6th August unanimously voted to leave repo rate unchanged at 4% and continue with accommodative stance of monetary policy as long as necessary to revive growth and mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward. Reverse repo was also unchanged at 3.35%. In terms of assessment, the document noted the fragile state of global and local growth even as domestic agricultural prospects have strengthened owing to monsoon and area sown. Overall, the MPC expected CPI to remain elevated in Q2 FY21 and likely to ease in H2 FY21 aided by base effects. Importantly the guidance remained dovish, noting that "supporting the recovery of the economy assumes primacy in the conduct of monetary policy" and that "in pursuit of this objective, the stance of monetary policy remains accommodative as long as it is necessary to revive growth and mitigate the impact of COVID-19 on the economy".

Given the limited marginal utility of conventional easing, both to the system as well as to the bond market, we were largely agnostic to a rate cut going into this policy. Importantly, our view was basis the marginal utility argument and not basis the recent rise in CPI. One cannot simultaneously worry about the massive growth collapse and inflation, at least not in the conventional sense. Another way to think about this supply driven recent inflation is that it will very unlikely have material second round effects in the form of wages and product price push. It is no longer continued easing of policy rates that matters as much as the assurance that the stance on rates and liquidity remains accommodative, as well as the continued evaluation of non-conventional measures.

Overall the RBI policy was a continued acknowledgment of the fact that the material role in the current context is of the RBI and not the MPC. The setting of the repo rate is irrelevant as the system now operates at reverse repo. The assurance of abundant additional liquidity and the execution of this promise rests with the RBI. Unconventional measures to ensure the financing of the higher public deficits happens without incremental tightening in financial conditions is also in the RBI's domain. Finally, regulatory measures to facilitate flow of credit and preserve risk capital also are squarely with the RBI. In such a scenario while the increasing irrelevance of the MPC has to be acknowledged and potential risks associated with the same need to be considered down the line, the fact of this irrelevance cannot be used as a justification to withhold the most critical components of non-fiscal policy that exist in the armory today. It is comforting to see that the RBI shares this point of view.

This is the second phase of global financial repression and is likely to be pronounced and sustained for developed markets. For countries like India, where long term financing needs are substantial, the saver will have to come into focus at some juncture. Meanwhile, investors are living with very low absolute yields on quality bonds with lower duration risk. Steep yield curves and wider credit risk premia are tempting avenues to increase returns. However, both these phenomena are logical pricing of the risks embedded in the system. Importantly, the magnitude of shock underway is unprecedented and the information available to assess its impact is thin. Therefore, it is very critical that investors follow a logical framework for allocation and not get pushed into taking risks that are outside their realm of appetite and / or aren't well thought out. Outside of agriculture, the macro narrative hasn't changed discerningly for the better for the rest of the economy. Hence, this isn't time to move into diluted credits despite the collapse in quality rates and it is critical to wait for an improvement in the underlying environment.

We are currently at a point where the acute nature of the shock is making the trade-off very much against the saver. However, over the medium term this will likely normalize at least for developing markets like ours. Alternatively, the environment would relatively stabilize and data will become clearer allowing for a better assessment of risk when reaching for higher returns. In the meanwhile, one has to live with this period in the least damaging way possible. In our view this is accepting lower returns for now rather than unnaturally expanding risk appetite.

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