The Event The RBI kept all rates unchanged in its monetary policy review today, in line with consensus expectations. However, the undertone in the policy seemed much more dovish than market was expecting; thereby causing some relief with participants. Analysis The market had gone into the event fearing that RBI’s tone will suggest that currency risks will be managed to the exclusion of all other considerations like growth. However, the central bank has indicated that but for currency volatility, the bias would have been to continue to ease monetary policy; given moderating WPI, prospects of softening in food inflation on better monsoons, and decelerating growth. The current tightening measures are justified in context of an ‘impossible trinity’ trilemma whereby the RBI ‘is having to forfeit some monetary policy discretion to address external concerns’. This can be interpreted as meaning both that the measures are ‘temporary’ and that the central bank is not very comfortable with these measures in light of other macroeconomic variables like growth and inflation. Indeed, the RBI says that the liquidity tightening measures ‘are aimed at checking undue volatility in the foreign exchange market and will be rolled back in a calibrated manner as stability is restored to the foreign exchange market, enabling monetary policy to revert to supporting growth with continuing vigil in inflation’. In our view, while this provides some measure of relief to the bond market, it undermines RBI’s own effort by triggering speculation as to the strength of their resolve. The other area markets were looking for some guidance on is just how temporary these measures are likely to be. Some guidance can perhaps be interpreted when the RBI says that ‘it should be emphasized that the time available now should be used with alacrity to institute structural measures to bring the CAD down to sustainable levels’. Given that the RBI wants the government to implement structural measures, it can be interpreted that the time it will allow via tight policy will be long enough to do so. However, given also the underlying bias as described above to have been rather easing monetary policy, it can also be interpreted that they would not want to keep this extra-ordinarily tight policy to remain for too long. Investor Takeaways All told, and in light with RBI’s comments in the policy today, we would assess the liquidity tightening measures currently in place to be extra-ordinary and not in any manner signaling a reversal in the monetary policy stance. We have emphasized this point before in our earlier communications (refer “Tinker, Taper……An assessment update for fixed income, dated 11th July). If investors believe our assessment, and indeed the RBI has shown bias today to restart easing once currency stability is achieved, then the current term spreads being offered by the yield curve have to be considered as an attractive entry point for longer duration. At the same time, the near term risk remains that the rupee remains volatile and the measures continue for longer than most in the market anticipate. A real problem here is assessing what exactly is meant by currency stability which in turn will enable RBI to unwind these measures. In our view, RBI’s current measures are step 1 of a 2 step process to be followed up by some measures to garner short term dollar flows (NRE bonds etc). It is possible that should such an announcement create a positive tailwind for the rupee, the RBI will use that opportunity to start to unwind its tightening measures in a ‘calibrated’ fashion. On the other hand, and in line with a fear RBI has expressed, if rupee remains under pressure on further QE tapering news from the Fed, the measures may have to be sustained for longer. The best course of action in our view and given the above, is for bond investors to average their new investments over the course of the next month. On our part, and as discussed before, we are slowly deploying our cash into duration over a period of time. August is a good month to do so since net government bond supply for the month is very heavy at INR 67,000 crores and should provide a good entry point (September is a net negative supply month which, all other things being equal, should be positive for bond prices). However, we must caution investors on 2 counts: 1. Investment horizon has to be 1 year plus. Also, if current measures sustain for longer than anticipated near term volatility in bond prices may very well be the order of the day. However, bond valuations are attractive enough to make sense over a 1 year time frame even with external and fiscal risks still in the system. 2. No one product fits all needs. Hence, investors should always match investment horizon and risk appetite to product selection. For instance, for investors desiring lesser volatility a short term fund may be the best option even if investment horizon is long term. For another section desiring greater visibility of returns even at the cost of liquidity, an FMP may be the most attractive. Bond and gilt funds should only be bought by investors desiring larger participation with accompanied larger volatility
Posted on: Tue, 30 Jul 2013 11:13:02 +0000
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