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Last updated: 15 Jul, 2021  

Rupee.9.Thmb.jpg Outliers: A Macro and Bond Update

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Suyash Choudhary | 15 Jul, 2021
A persistent theme of Indias bond curve is its very attractive steepness even up to mid-duration points. This has allowed for substantial carry plus roll down benefits from a portfolio standpoint. The assumption in this sort of a strategy is that, while bond yields can rise, they should do so relatively modestly and in an orderly fashion for the excess carry and the benefit of roll down to manifest itself.

There have been two episodes of sharp intermittent volatility in bond markets that have disturbed this trade since the start of the calendar year. The first was the very first few months of 2021 when the global reflation trade got a fresh wind with an additional large US fiscal stimulus besides a subsequent accelerated pace of reopening in many parts of the developed world. This led to a substantial rise in global yields, commodity prices and inflation expectations. Our own bond markets had to understandably react in sympathy as well leading to a short period sharp rise in yields. The second was more recently with India's CPI reading received in June throwing a nasty surprise versus expectations. Given the underlying backdrop of firm global commodity prices and the recent sharp rise in oil, this threw market expectations with respect to local policy unwind into a fresh 'blue-sky'.

However, since then two notable events have occurred: One, the RBI Governor in a recent media interview seemed to indicate continued preference for the need to nurture growth recovery. Even has he referred to being watchful on inflation momentum, the reading received in June hadn't apparently upset the 'applecart' of preferences so to speak. And then the CPI reading received in July soothed further by under-shooting consensus expectations and showing a drop in some of the momentum attained in the previous reading, even as it was still outside the upper band of the current targeting range. However, it is quite likely that a near term peak has been attained and that CPI progressively falls into October � November helped by a generous base effect.

Cash Versus Bonds

We had discussed in detail in our previous note the efficacy of cash as a hedge against market volatility. We have also before dwelled extensively on the trade-off: that while cash seems the best hedge against market volatility (better than swap), it is also true that the carry loss embedded in running cash is significant. As an illustration, only if the five-year government bond yield rises by more than approximately 5 bps a month will holding cash outperform holding the bond. Hence, a portfolio hedge cannot have an indefinite shelf life. Having a view that yields will rise is also not adequate justification for holding large amounts of cash, given the steepness of the curve. Unlike in some previous market cycles when yield curves have been relatively flat and holding cash has hurt only when bond yields have fallen, as noted above in the current context yields have to rise substantially for cash to outperform. Hence, using cash or portfolio hedges has to be reviewed continually and large cash positions should probably only be used in periods of very high uncertainty which are marked with significant probabilities of outlier risks such as (in our assessment) the period between the last two CPI prints. This is because had the print received in July also exceeded expectations (some analysts were expecting around 7 per cent) then the market would have started expecting imminent policy normalisation. It is to be noted that one outlier print informs market expectations substantially since it elevates the average CPI expectation for the full year and distorts analysts perceptions as to what month-on-month momentum to assume going forward.

However now that the CPI print has passed 'safely' and there's a relatively reassuring interview from the Governor as well, one can probably assess that some of the outlier risks may have passed. To be clear, commodity prices remain firm and there is an added element of monsoon delay locally to contend with. But these are within the realm of modellable risks (unless crude oil prices spike substantially again) and seem consistent with an underlying view of a gradual increase in bond yields. On the flip side, peak growth expectations seem to be past us (China seems slowing as well) while infections seem on the rise in parts of the world again. This phase of 'learning to live with the virus' may very well weigh on consumer sentiment and activity to some extent at least in parts of the world that aren't substantially vaccinated and in turn may inform the element of patience in monetary policy conduct as well.

Portfolio Update

In light of our assessment of presence of outlier risks, we had substantially raised cash/near cash in our active duration funds over the past month. However, this wasn't supposed to be an indefinite strategy given the significant carry loss involved. Factors discussed above have to some extent reduced these outliers in our view even as the underlying environment remains somewhat uncertain. Given this we have reduced cash/near cash to approximately between 18 � 28% in our active duration funds as at July 14, 2021. Our preference remains for four-five year government bonds for the most part where we assess the carry adjusted for duration risk is the most compelling. As always, portfolio strategies can change at any time basis our evolving assessment of various factors in light of the active duration nature of these funds.

(Suyash Choudhary is Head � Fixed Income, IDFC AMC)
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