There has been a sharp repricing in policy rate hike expectations by central banks in many major markets since the start of this year. The most relevant and notable of these is the US where the 2 year swap yield (a measure of market expectations of rate hikes in the current cycle) has increased by around 175 bps this year. Even as the global volatility had naturally rubbed upon India as well, we had nevertheless been relatively ‘safe’ till very recently. This changed in the April monetary policy review, where RBI / MPC executed a pivot in assessment (https://idfcmf.com/article/7569 ). If this was meant to be a small step towards neutrality so as to purchase future flexibility in actions, then the market definitely didn’t take it as such. The revised inflation trajectory in light of the recent massive geopolitical shock was well expected. However, market has come away confused as to whether RBI still adheres to recent characterisation of inflation as being largely supply side; especially after some reference to ‘real’ positive policy rates in the post policy press interaction. This is always an unwieldy concept to use when communicating to the public / markets at large, and especially so when the assessed inflation trajectory is exceptionally volatile and is being subjected to the most intense supply side shock in many years. All views have been let loose as a result and the 2 year swap yield has risen some 60 bps since the policy date till the time of writing. With these recent rises in swap yields, the Indian market is now expecting RBI / MPC to hike the repo rate in every policy for the next year (with probability of a 50 bps hike in one or more of these). Not just this, as per market pricing these rate hikes are expected to continue over the next financial year as well thereby taking the effective overnight rate higher by almost 275 bps over the next 2 years, from 3.75% currently.
The Endgame
It is our view that we are decidedly in the last leg of the rate hike cycle pricing. This seems more definitely applicable in India, but could also be true in many other parts of the world. Indeed in many such places where rate hike expectations have been built in aggressively over the past few months, there is already some giving back on these expectations although this is marginal so far. Even in the US, the much highlighted 2 year to 10 year yield inversion has corrected sharply and is now at approximately 40 bps positive sloping. Thus while in all of these geographies markets still expect central banks to hike, in many places there is now a rethink underway on whether they will be able to do so much beyond what is perceived to be the long term neutral rate in these countries.
RBI itself has spoken many times before on how the cycle has been somewhat different for India. That it is so far silent on the magnitude of rate hike pricing is thus all the more surprising, given its general assessment that our inflationary pressures are largely supply side (there is no reason for this characterisation to change even as the expected trajectory of inflation is now revised higher on account of this significant commodity shock) and that growth momentum has been already slowing. This notwithstanding, our view remains that peak effective overnight rates will be lower in this cycle than in the last and thus the extent of market interest rate hike pricing is decidedly overdone. That said, a few observations below:
- As can be seen, there is a world of difference between the actual actions thus far by the central bank and what market curves are already pricing. As discussed above, in the case of India the swap curves are pricing in an effective overnight rate in 2 years much in excess of what we expect them to be. This is based out of our fundamental view about this phase of the global macro cycle which we have elaborated upon before. Briefly, global growth dynamics post the outbreak of pandemic have been driven by a very large and inherently unsustainable stimulus coming out of developed markets (DMs) which otherwise have quite modest trend growth rates. Side by side it can be argued that trend growth rates in some key emerging markets (EMs) have actually been slowing (China and India as examples). Now this stimulus (chiefly fiscal but also monetary) is getting unwound. It is to be noted that the pace of adjustment matters as well, and not just the new levels. Thus while it can be argued that fiscal and monetary policies are only being ‘normalised’ in DMs, they are nevertheless being made to adjust at a very rapid pace over a relatively short span of time. Also this is happening just when we are in the midst of an exceptionally large commodity price shock. The end result is a notable fall in sentiment with both consumers and businesses, with consequent possible implications for economic activity down the line. It is also to be noted that in such a ‘stagflation’ scenario, central banks obviously cannot be hiking rates till near term inflation comes back to target range. Thus to quote US CPI at 8% (or India’s at 7%) to try and assess the quantum of rate hikes ahead is probably dangerous in our view. If one thinks through it, that is a sure-fire recipe for overtightening policy (remember monetary tightening acts on economic activity with a lag). Instead, the rate hike cycle may only run so long as growth concerns become large enough for central banks to stop worrying too much about the second order inflationary effects of the commodity shock. This is likely to happen sooner in India given our already relatively weaker growth trajectory and the much more muted total fiscal and monetary responses here when compared with DMs. Thus, we don’t think there is a very long runway for a rate normalisation cycle ahead and while RBI may begin well it remains to be seen how long they can keep hiking. At any rate we reiterate that given our view as summarised above, swap pricing on expected rate hikes seems quite excessive.
- However, the above doesn’t mean that because ‘everything is now in the price’, things will only be easy from here on. Markets almost never behave this way. In the near term the dominant theme is central bank tightening in response to run away inflation. Our next CPI print is likely to be comfortably in excess of 7% and looks to be on track to easily breach the 6% ‘cap’ for 3 successive quarters. Further, geopolitical tensions continue to simmer with always a risk that a new flareup brings further spikes in commodity prices. Thus just because we are in the last phase of the rate hike pricing, doesn’t mean that market cannot overdo it further. However, it has important implications for investor behaviour. The general narrative one hears is of RBI commencing a rate hike cycle and that one should hence turn defensive (money market and floating rate bonds). As against this, we are saying that market is forward looking in nature and is already discounting more rate hikes than RBI is likely to deliver. Thus, and even while acknowledging the prospects of volatility over the next few months, our view is that now is the time for investors to start scaling into medium duration bonds with a sufficiently long investment horizon, rather than looking away from these. This is especially true when one factors in the carry buffer built in owing to steepness of the curve (more on this below). If one agrees with what is being said here then it is important to sort the forest for the trees. Thus a short term defensive posturing risks looking away from the bigger theme in play in our view, which is of market rate hike expectations peaking. As an analytical example, a floating rate bond should now be converted into fixed rate by receiving swaps (if one agrees with our view that the swap curve is overpricing potential rate hikes). However, this is unlikely to happen in a big way given that such bonds are largely being held in short duration products (that can’t afford the rise in duration that receiving swaps would entail). Also, such a trade may be highly illiquid and thus extremely unwieldy to unwind down the line.
- While the rate hike pricing by market may be at or near the top, this doesn’t mean that supply premium in bond yields is also peaking out. The new borrowing calendar is only starting now and market will be called upon to absorb a substantial supply of government bonds week after week. This means that buying long duration (say 10 year and beyond) may not necessarily be the best expression of a view that market is over-discounting RBI rate hikes. To refresh a decomposition of the yield curve, the spread between 2 year and 4 year government bond is approximately 100 bps still despite the more aggressive rate hike pricing in the last few days (this should have flattened somewhat, logically speaking). Whereas, 4 year to 10 year spread is around 75 bps. This makes the 4 - 5 year sector decidedly the best play, in our view. Another way to look at this is that, purely as an illustrative example, in 2 years’ time the current 4 year bond yield could be higher by almost 100 bps (it will be a 2 year bond by then) and the mathematically calculated holding period return will still be similar to what the current 2 year bond is yielding. There are a few important takeaways from this calculation: One, it is exceedingly unlikely that a 2 year government bond 2 years from now will yield close to 7.5%. If it turns out to be lower (could be considerably lower in our view), then the 2 year holding period return on holding a 4 year bond today for the next 2 years is likely to be much better than what can be made by merely investing in a current 2 year maturity bond for this period (although ‘certainty’ of returns is obviously higher when maturity of bond is matched with time horizon for investment). Two, although it sounds almost funny to speak about this in the current market phase, one needs to be aware that reinvestment risk may turn out to be a consideration down the line. Thus if longer term investors are buying 1 – 2 year bonds just for surety of returns, they need to be aware of potential reinvestment risks in this strategy compared with directly buying a 4 - 5 year bond today. Note that this observation is valid only because of the extra-ordinary steepness that still exists between 2 and 4 year rates despite the rate hike pricing now being in a relatively mature phase. At some juncture, active duration strategies may want to pursue even longer duration. However, as per our current view, this may need to wait till when one is surer about bond supply premium beginning to peak out.
Conclusion
Even though the actual rate hikes are only now commencing, we believe that market expectation of future rate hikes is already ‘ripe’ and decidedly in its endgame. This still means volatility for the next few months, since the narrative that has momentum currently is one of runaway inflation and central banks panicking. However, for reasons mentioned above, we think that this will eventually settle down and that in India markets’ rate hike pricing may already be considerably in excess of what is eventually likely to transpire. However, bond supply premium is yet to peak. All of this means that, unlike the common going around narrative, this is the time to start scaling into mid duration bonds. Defensive posturing, including into very near maturities and floating rate bonds, has to be looked at tactically at best and always while keeping an eye out on the ‘bigger picture’, in our view.
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