Indian Bonds

A lot has happened over the past month or so. Oil prices are up sharply, with Brent rising more than 30% from the low. Global bond yields have sold off sharply with some like Germany standing out in their scope, rising from 7 bps to 63 bps in a matter of less than 20 days. Market traded inflation expectations in the developed world have also risen meaningfully, although growth data remains almost uniformly weak across most of the world. For India, higher oil has dented sentiment for bonds. So has the prognosis of weak monsoons and the corresponding fear of higher food prices. Finally, some general impatience with respect to Indian assets seems to have crept in with actual economic progress lagging expectations; especially given the strongly overweight positions that investors have been running in India. As a result of these, bonds have sold off quite meaningfully locally while the rupee has also borne a fair share of the brunt lately.

 

Clearly the environment is throwing up a lot of noise and in context of adverse price action it becomes extremely challenging to interpret the course of action ahead. In such a scenario, the best thing to do in our view is to go back to the underlying framework that made us buy bonds in the first place and reassess it for incremental developments. We had done this in our most recent note (please see "Updating Our Framework For Recent Developments", dated 23^rd April for details) and came away with an assessment that though the easy money has been made on Indian bonds and one has to hold a more 'bottoms-up' framework from here on, the fundamental reasons to still be long duration continue to be in place. We also discussed the factors that we are monitoring and upon which the bullish view is contingent. The intent here is to further refine the discussion to its most simplistic essential hypothesis with the hope that it enables stripping out some of the noise that has lately sprung up.

 

As has been discussed multiple times before, the RBI is now on a CPI target plus real rate framework. To recap, the CPI target by 2018 is 4% (mid-point of 4%+/-2%) and the real rate target mentioned is 1.5% - 2%; at least in the initial part of the cycle. Now, the following points need to be noted:

 

1.      If the 4% target is achieved then clearly bond yields will be meaningfully lower by then. It is almost inconceivable to imagine an almost 4% real positive yield on sovereign bonds (which is what will be the case if bond yields don't rally in the face of falling inflation).

 

2.      The question then is whether the target is achievable. Presumably it is quite achievable if both our large institutions, the government and RBI, are working towards achieving it. Now, no one at all doubts the RBI's commitment to the target. A large reason for the current frustration on bonds is precisely the confidence the market has that the RBI is fully committed to responding in a way that preserves its 4% target. The problem is that markets are not convinced that the government is as committed to achieving the target. If they were, then bond yields would already be falling in anticipation of much lower forward inflation.

 

3.      On the face of it, it should sound strange that markets don't believe the government's commitment towards the 4% target. After all it has signed on to the MoU with the RBI that not only mandates the central bank to pursue 4%+/2% by 2018 but holds it responsible if it fails to do so. Simultaneously the government is very vocal about its desire for lower interest rates. If it weren't serious about helping the inflation fight, it should have resigned itself to higher rates; which is clearly not the case. Not just that and all the noise on higher food prices notwithstanding, on the ground prices remain relatively well contained just as they have been through the last year's sub-par rains as well as the recent episodes of unseasonal rains. In fact inflation on its current trajectory is undershooting the RBI's most recent forecast by a good 50 bps or so. Obviously the risk is that this will cease to be so especially in context of a sub-par monsoon forecast ahead and the recent pressure that the government has come under with the opposition branding them as being 'anti-farmer'. Indeed, our own biggest trigger ahead as explained in detail in previous notes is government's approach towards food management. However all these concerns including our own again do not sufficiently respect the simple fact described above: that the government has signed on to a more aggressive inflation target and it wants it done without higher interest rates. Hence it stands to reason that it intends to contribute more to keeping inflation low and stable than it expects RBI to do.

 

4.      So long as the above arguments are intact, one should be able to live through bouts of oil and currency volatility provided of course that the volatility is not stretched to extremes. It must be remembered that neither the government nor the RBI have built their macro-economic forecasts assuming oil to be at USD 50. If that sustained it would have been a significant lottery for us. But let's face it: long term investors into bond funds cannot build a view basis a lottery. A similar argument holds for monsoons. RBI policy cannot be held hostage to every cycle of monsoon. Suppose this year's monsoon is good and helps to bring down inflation. Suppose the RBI cuts on the back of that only to find that next year's monsoon has failed. Will it then go and hike? When the whole scenario again could be different the year after that? When any interest rate change by the RBI actually impacts the economy with a 3 – 4 quarter lag? Clearly the RBI's response function in context of a medium term CPI plus real rate framework cannot be as simplistic as that.