There, there: Monetary Policy February 2021

By Suyash Choudhary

The monetary policy was set against a backdrop full of push and pull factors. Some of them were as follows: Resurging domestic growth in context of a global reflation trade leading most boats, including commodity prices, higher.

A wider budget deficit that has thrown up unexpected additional bond supply, especially for this year but even for the next. This has fed market anxiety that was already developing since the reintroduction of 14 day variable reverse repo (VRR) earlier in the year. As a result government bond yields at the 5 year point as an example have risen almost 50 bps since the start of 2021, threatening to unwind a large part of recent transmission just as corporate sector borrowing may be getting ready to pick up. A welcome fall in CPI (Consumer Price Index) in the near term as vegetable prices corrected sharply and momentum of some other items started to soften.

Given these, the Governor had a somewhat complex balance to execute in the current policy, with the attendant risks of not being able to fully satisfy all areas of addressing that needed attention. From a bond market perspective that is somewhat of what seems to have come through, at least for now. But first the details:

1. All rates as well as the accommodative stance and elements of forward guidance were unanimously kept unchanged.
2. The renewal in growth, consumer and industry confidence, funds flows, are all noted. Real GDP (Gross Domestic Product) forecast is for 10.5 per cent growth in FY22 with the growth front ended and distributed as 26.2 per cent, 8.3 per cent and 6 per cent for the first 3 quarters for FY22. There is nothing here that is out of line from consensus private forecaster expectations.

3. Inflation is assessed to have factors working both ways with near term food price outlook benign and easing of supply chains affecting core CPI benevolently on the one hand, compensated by rising cost pressures and enhanced abilities for pass-through to output prices on the other. The net assessment is one of lower CPI for the current quarter, but somewhat higher than earlier forecasted in Q2 FY22. In numbers it translates to 5.2 per cent each for Q4 FY 21 and Q1 FY 22, 5 per cent in Q2 FY 22 falling off to 4.3 per cent in Q3.

4. The monetary policy committee (MPC) again implores the government "to create conditions that result in a durable disinflation" with focus on unwinding taxes on petroleum products and taking proactive supply side measures even as from a monetary policy perspective it judges that the recovery "is still to gather firm traction and hence continued policy support is crucial".

5. Developmental and regulatory measures taken include:

   a. Restoration of cash reserve ratio (CRR) dispensation of 1 per cent of net demand and time liabilities (NDTL) given last year to be unwound in two phases of 50 bps each beginning late March and late May.

   b. Additional 1 per cent of NDTL dispensation given on statutory liquidity ratio (SLR) for availing funds under the marginal standing facility (MSF) extended by 6 months to end September.

   c. Held to maturity (HTM) hike of 2.5 per cent for SLR securities acquired between September - March, now extended by one year to March 31, 2022. Accordingly, eligible SLR securities are now expanded to include securities acquired over FY 22. Importantly, this relaxation will now start unwinding from the quarter ending June 23. This is an important issue for the bond market (more in the table)

   d. Retail investors are being allowed to open gilt accounts with RBI. This is an important measure and the move is to provide retail investors online access to the government securities market -- both primary and secondary -- along with the facility to open their gilt securities account ('Retail Direct') with the RBI.

   The table highlights RBI forecasts, including comparisons to previous ones as well as imputed forecasts from those available:

   Takeaways

   It is well understood that the level of India's overnight rate is at emergency levels and hence must be normalized over a period of time. This is also significantly discounted even in instruments like swaps where pricing doesn't get distorted (unlike bonds) with the pressures of demand and supply. That said, one has daily price movements because there are 2 sets of opinions; so one's impression of adequate discounting is a function of one's expectation of the pace of unwind ahead. The real challenge when executing the unwind (irrespective of slight variations in the pace) is that the starting point is one of already very steep yield curves. To go back to one of our favourite examples here, the 6-year government bond is already in the vicinity of 6 per cent. A further 25 bps rise over a year means that a 5-year bond one year from now will be at 6.25 per cent. Even then holding on to the bond over this period and providing the rise in yield is not greater, makes better return than what even a 1-year NBFC commercial paper may provide if bought today. Also as the overnight rate normalizes, the curve will obviously flatten. So purely hypothetically (not a view) a 6.25 per cent rate on the 5-year can be seen consistent with a close to 5 per cent on the overnight rate, and still the curve would be quite steep.

   While we have made the above argument before in context of our portfolio strategies, it also to us represents the best quantification of the dilemma that the RBI currently faces. It is not enough for analysts to suggest that RBI should accelerate the unwind in light of evolving factors, till they simultaneously incorporate this dilemma into their recommendations. Left to its own devices, the bond market will keep travelling on the path of transmission unwind irrespective of the Governor's call for an orderly evolution of the yield curve. This is because we continuously overestimate the capacity/propensity/appetite to intermediate with market participants. A mini version of this has been on display over the past month when a flawed understanding of the intent behind VRR, alongside the bond supply shocks in the budget, have already caused a 50 bps unwind destroying significant portions of market risk appetite along the way.

   Given the above, the RBI needs to mute (not break) the linkage between the recalibration in the overnight rate and its exaggerated transmission to higher up the curve. A hint around this was already given today when the Governor referred to the CRR unwind opening up "space for a variety of market operations to inject additional liquidity". Thus we fully expect unwind/absorption measures ahead around liquidity (CRR unwinds, term reverse repos, MSS (Market Stabilization Scheme) issuances at some point) to co-exist with twist and outright OMOs (Open Market Operations) to ensure that the effect higher up the curve is blunted. The extension on HTM dispensation is welcome but will be more helpful if the unwind schedule isn't too aggressive, without which it doesn't really help the problem described above very meaningfully.

   Investor Implications

   The view remains one of gentle bear flattening, with the bulk of the heavy lifting being done by the very front end rates as RBI's normalisation schedule commences. This will continue to allow for positioning at various points on the yield curve where the carry obtained adjusted for price erosion due to yield rise will still make sense. This has been and remains our guiding principle. The corresponding strategy for investors may involve some amount of "bar-belling" where, alongside traditional core investments like quality roll down products, some combination of very short end (overnight funds, near term deposits) and intermediate duration strategies (focused on maturities largely in the 6 - 7 year area) may be deployed to optimize on the RBI's gradual normalisation in context of an already very steep yield curve. It is important that investors remember to weigh intermediate duration strategies with very short maturity instruments as well so that the average maturity of their investment portfolios does not rise. It is also relevant to note that these strategies account for a rise in yields over the period ahead, provide these aren't disruptive over the time frame. This risk can also partly be mitigated by having sufficiently long investment horizons.

   (Suyash Choudhary is Head - Fixed Income, IDFC AMC. Views expressed are personal)

Source: IANS