Delusion: A Year in Macros and Bonds
SUYASH CHOUDHARY | 27 Dec, 2022
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"I know delusion when I see it in the mirror": Taylor Swift
naming our year-end piece around this anchor word, we went back to see
the exact dictionary meaning of 'delusion'. We found this: "a false
belief or opinion about yourself or your situation". Encouraged thus
that we couldn't find anything better to describe what went on over
2022, we have proceeded to put pen to paper.
At the start,
however, one must admit to not being entirely unsympathetic towards
someone being accused of being deluded. After all so long as they
weren't doing anyone any harm, and the state of delusion served to keep
them relatively happy, who are we to judge that an alternate state of
being may have proved to be better?
Also, who is to say who is
in delusion and who is not but with the benefit of hindsight; when the
evolution of circumstances, the unravelling of the thread as it were,
conclusively proves that it were so? Even more, if one considers Bob
Dylan's advice to not speak too soon "for the wheel's still in spin" and
there's no telling who it is naming, then who is to say that the final
reckoning has indeed happened and therefore what is being proclaimed
actually is with the benefit of hindsight, and not just a rush to opine,
to render verdict, when in fact the game is still not over?
reader must by now be feeling that, whatever else be the case, the
author of this piece is almost certainly delusional. Again, we won't be
unsympathetic if this is indeed the conclusion drawn. Though we are
often reminded that our prose tends to turn torturous even in our
regular investment notes, we reserve the biggest test of the reader's
indulgence for these year-end pieces. That said there is a limit to this
as well and if, like what is happening with us more and more lately,
there is now lesser patience generally with faux intellectualism then we
best turn speedily to the matter at hand.
The Delusion of Central Banks
easy to forget, but till not very long back the problem in developed
markets was too low inflation. Japan had been struggling on this front
for ages, Europe seemed to be going that way, and even the US was
getting worried along similar lines. The drivers of sub-optimal
inflation were deemed to be almost structural in nature. The tightest
labour markets in generations had failed to generate any meaningful
uptick in wage growth thereby cementing the view.
Fed had unveiled an average inflation targeting framework that allowed
for inflation to run higher than mandated for a period to compensate for
previous episodes for lower than target inflation. In the process,
targets would be met on average and inflation expectations would
(hopefully) anchor around a point consistent with the 2 per cent target,
and not below. Also the Fed would be reactive to inflation rather than
proactively trying to anticipate it.
With this backdrop, the
Covid shock effectively turned the Fed into a single variable targetter
(only employment) since the risk that inflation would return seemed not
even worth a thought. Unfortunately this coincided with a super
aggressive fiscal expansion with a significant portion of this involving
direct cash transfers to people, a shrinkage in labour force, supply
side congestions, and finally, a massive supply side shock with the
Russia - Ukraine war.
A similar story, with some variations,
played in other developed markets with unwieldy inflation now almost a
consistent theme in many such geographies.
The delusion started
cracking sometime late last year, but did not break conclusively till
well into the current one. Thus, for example, even though the Fed
started to realise that something wasn't quite right with its view of
the world, it nevertheless persisted with balance sheet expansion and in
the process continued supporting an already overheated housing market,
amongst other things.
Elsewhere in the world as well, central
banks still seemed reluctant to show anything but a planned pivot to
tightening till as late as early this year. This was despite concurrent
inflation readings running much in excess of targets. Eventually,
however, the gravity of the situation sunk in and pretensions that the
tightening process could be orderly or that central banks could get
inflation back to target while guiding respective economies to a soft
landing were conclusively set aside. Instead, as the year turns, shelter
is now being sought in the age old truism that inflation control is
necessary for sustenance of an economic expansion.
way, central banks are now having to defocus attention from near term
economic pain that will possibly be inevitable if sufficient
dis-inflation is to be achieved to get back to targets over time. They
are also having to rely less and less on their powers of forecasting
given recent history there, and instead accord more importance to
It isn't lost on them that monetary policy acts
with 'long and variable lags', and that the level of uncertainty may be
especially larger this time given the unprecedented pace of tightening
that has been undertaken over such a short span of time. However, given
that there is no means to rewind the clock, they are settling for the
least undesirable option presented to them currently.
case has been somewhat different. The scale of fiscal and monetary
stimulus was nowhere as aggressive in the first place. Also, after an
initial hesitant start, the unwind process has been largely proactive,
especially when one also takes into account the shrinkage in RBI balance
sheet (even adjusted for revaluation effects of our forex reserves).
Thus while inflation here has proven to be stickier as well, and with
the benefit of hindsight would have possibly been better served had we
got off emergency levels of accommodation a bit sooner, the extent of
deviation is much more modest as compared with developed markets.
the policy normalisation cycle itself has well and truly caught up, and
with a lag should have the requisite impact on aggregate demand.
The Delusion of Markets
bank bashing this year reminds one of a pinata, except that it's
unlikely that toys and sweets are waiting to tumble out at the end of
the exercise. That is to say, at a macro level the prospect of a soft
landing as noted above seems to have got significantly darker for
developed markets. The path to a sustained lower inflation profile is
via softer wage growth, which in turn requires appreciably higher levels
of unemployment than what is the case currently. Even as headline
inflation rates will come off significantly, the discussion next year
will likely shift to time frame required to sustainably re-attain
targets and how long this will require central banks to keep rates at
cycle peak levels.
Thus demand destruction in goods and housing
won't likely be enough even as it pulls down headline inflation. Only
percolation into employment and wages may provide the necessary signals
on durable inflation fall. This means that there is little chance of a
central bank 'put' emerging even when signs of growth destruction get
much worse than what is the case currently. With this backdrop we turn
to some observations on the markets, specifically the US.
time of writing, markets are broadly pricing terminal Fed funds rate at 5
per cent and cuts of approximately 60 - 65 bps over late 2023 into
early 2024, and then sharper cuts over the rest of 2024.
yield curve is deeply inverted, with the 10 year minus 2 year spread
broadly the most negative since the early 1980s. Inflation expectations
have come off and aren't really portraying any material concerns about
the future of inflation. High yield credit spreads on aggregate, though
much higher than 2021 lows, are not flashing any great warning and in
fact have come off significantly from their mid-year levels.
generally, and sporadic accidents notwithstanding, asset and financing
markets are broadly not exhibiting overbearing worries.
summary that the above paints, in our interpretation is as follows:
Cycle peak in Fed funds rate is much higher than what markets believe
the long term neutral is. This is reflected in the shape of the yield
curve, with the extent of inversion probably signifying distance of
average rates in this cycle (hike, peak, and then cut as denoted by 2
year yield) from the long term neutral (10 year); both adjusted for
Markets also believe that the cycle trajectory
of Fed funds rate will be enough to curtail inflation (as shown by
inflation expectations) while not inflicting an unduly large sacrifice
on growth (as evident in credit and asset markets). Indeed, markets are
currently assessing the stickiness of the problem to be moderate enough
to allow the Fed to actually start easing later in 2024 itself.
course, it is possible that the scenario laid out above actually plays
out. As US consumers continue working through the accumulated fiscal
transfers on their balance sheets, in an environment where real income
growth has been negative for a while and on the margin growth clouds are
decidedly darkening on the horizon, one may reach a point not too far
in the distance where consumption demand falls off sharply with
consequent ripples into hiring and wages.
One must especially be
alive to this possibility, given the 'long and variable lags' on
monetary policy impact after such an aggressive rate hike cycle. Thus
the turn in inflation may be conclusive enough for the Fed to start to
ease policy. Market financial conditions will amplify the signal by
easing more and hence a soft landing-ish kind of scenario plays through
keeping everyone broadly happy.
Equally almost, one must also
consider the possibility that we are still underestimating the scare
that developed world central banks have been put through. As discussed
above, the issue for the longest time was too little inflation. The
bedrock of monetary policy thus was to find ways to generate more
inflation, and in the process come up with more and more innovative ways
to ease financial conditions beyond the bounds of what was
conventionally possible. Suddenly a playbook from four decades back has
had to be dusted up and referred to.
And the book cautions
against the temptation to start easing policy at the first sign of
inflation softening. Irrespective whether that literature is relevant
today, this is the best that central banks have to go on. Also, to be
fair, unanchored inflation would open up a box that would be much more
difficult to close than growth collapsing for a while. If the problem is
the latter, central banks will be back into familiar territory of
operation. Thus their reaction function ahead will be decidedly
asymmetrical, with much greater tolerance for continued growth slowdown
and much lesser for any interruption to the pace of disinflation.
the Fed Chair has said as much clearly articulating preference for
running the risk of overtightening (which can be unwound later through
tried and tested tools) versus finding out that enough tightening wasn't
done (which would take macro dynamics into unchartered territory). One
wonders whether enough 'skew' is there towards this eventuality in
market's current probabilistic distribution of future outcomes.
The Growth Delusion
it isn't apparent by now, here's an explicit admission: there is some
force fitting of section titles here to be consistent with the theme of
the piece. This may make the headlines sound harsher at times than how
they are intended. On review we find the same admission in last year's
piece as well. Chalking this then down to the perils of writing
theme-based end-of-year notes, and with this warning in place, we must
Higher inflation has brought higher nominal growth rates
this year. There has, no doubt, been an underpinning of higher demand
as well. However, the effect has been somewhat exaggerated when one has
looked at nominal variables, owing to the inflation component. However,
as one looks ahead it is likely that nominal growth rates come off
sharply. This will be both on account of inflation falling as well as
real growth rates weakening. Nominal interest rates may fall as well,
but it is unlikely that this will happen as sharply if the discussion
above proves to hold true.
Although hopefully temporarily, but
this will on the margin make debt servicing that much more onerous.
Nominal revenue assumptions going into budget making exercises will need
to take this into account, with the obvious risk being that, after
handsome overshoots this year owing to much higher than anticipated
inflation, there is a tendency to overestimate these for next year.
Central banks, especially in developed markets, who have had a 'free
hand' thus far in addressing inflation may find the environment much
less conducive next year.
As nominal incomes experience the
force of gravity and job losses start to bite, it may get that much more
difficult to explain the necessity of persisting at peak rates;
especially as this would happen not at (say) 7 per cent inflation but at
(say) 4 per cent. There may be more fractures within monetary policy
committees (MPCs) themselves and more dissents to the eventual decision.
these are less relevant for India but worth a discussion nevertheless.
Dissent has already surfaced on policy but given that our MPC is only
tasked with setting the repo rate and vocalising the stance, there is
only so much additional differences of opinion one can have. This is
especially as, if our view is right, we are already at peak cycle repo
rate or at worst 25 bps away from it.
Once stance turns to
neutral, it is likely that for a while action shifts back to RBI
measures as opposed to MPC ones, as was true for most of the pandemic
period. One of the key things markets will watch for next year is when,
how, and by how much RBI chooses to augment system liquidity (core
liquidity would have been very close to zero by then). As the year
progresses it is possible that MPC discussions get more active again.
This is in context of our view that though India will relatively do
better on growth than most places around the world, we will nevertheless
slow as well reflecting the global slowdown. Basis this we also believe
that the general view on domestic growth for next year (including from
RBI) is a shade too optimistic.
A Look Back At Our Own Delusions...
the first part of 2022, there were two factors that weighed on us: One,
we were cognisant that a policy normalisation cycle was coming and were
on the lookout for active duration management opportunities to help
curtail potential portfolio volatility from the same. Two, the yield
curve was steep with the 4-5 year maturities seemingly providing enough
cushion against an eventual normalisation of RBI repo rate towards the
pre-pandemic level of 5.15 per cent.
The same steepness meant
that the carry loss in running cash positions was significantly large
whenever one chose to take cash calls in pursuit of navigating
volatility. In this context, stickier dovish RBI commentary (refer
February 2022 policy as an example, https://idfcmf.com/article/7085) and
reluctance to take the first meaningful step towards rate normalisation
heightened the carry loss aspect especially since, as mentioned above, 4
year government bond valuations (between 6 - 6.25%) seemed to have
enough protection already built in, in a scenario of a slow
normalisation cycle to early 5 per cent's on the repo rate.
delusion, as it turned out, was to not allow for longer periods of cash
calls, assigning greater weightage to carry and valuation considerations
mentioned here versus the steadily rising prospects of global
volatility. Consequently, we suffered the full impact of the bolt from
the blue that arrived in May in the form of an inter-meeting hike in
both repo and CRR. This also served to un-anchor terminal rate
expectations for the market. In fact almost the entire brunt of rise in
yields (save for in the very front end) was felt over approximately just
one month between early April and early May. Our most overweight
government bond's yield as at time of writing is approximately at the
same level as it was in early May, but rose roughly 100 bps over the one
month prior to that.
This has probably been one of the more
passive years for us in terms of changes to investment strategies. That
is because once the damage was done over the short period of one month
early in the year, the focus then shifted to reassessing the underlying
framework to see whether one should now turn reactive and 'cut out'.
our own assessment of terminal RBI repo rate has been revised higher
through the latter part of the year, there were nevertheless certain
underpinnings to our framework that we held on to. For one, and even as
the Fed rate cycle has turned out to be stronger than earlier envisaged,
we rejected the idea that India needs outlier rate hikes (or be in
lock-step with the Fed), supposedly to defend the rupee. Reasons behind
our thinking have been documented through the year in our various
investment notes (as an example, https://idfcmf.com/article/9850).
were looking at the post Covid evolution of India's fiscal and monetary
response and didn't find this to be at all excessive, especially when
compared with what went on in developed markets. Thus we were
comfortable with the idea that at cycle top RBI to Fed policy rate
differential can actually be quite narrow, even as it will widen again
later on as US inflation comes off and the Fed finds more room to cut
than us down the line.
This is because the current cycle peak in
Fed funds rate is much higher than their long term neutral compared
with RBI's cycle peak compared with our long term neutral. As the year
closes, we are happy to see this idea having more traction with most of
the market now comfortable with the idea of a 6.50 per cent - 6.75 per
cent repo rate peak against Fed's 5 per cent. This importantly in turn
has lent stability to our investment strategies.
... And A Look Ahead To (Potentially) New Ones
residual 'nit-picking' that remains with respect to terminal policy
rate expectations in major markets (including our own) will hopefully be
put to rest in the first few months of the new year without any major
further disruptions. Attention will then shift from 'how far' to 'how
To state the obvious, the primary driver for expectation
changes will be material shifts in inflation and not the continuation of
growth slowdown. In the meanwhile financial conditions may remain tight
driven by high nominal policy rates and continued central bank balance
sheet shrinkage. The latter may indeed require more general attention
than has hitherto been given, including in India. Importantly, this will
happen at much more subdued nominal growth rates. This may weigh much
more on the more fragile balance sheets and business models than
hitherto has been the case.
Put another way, unless the market
expectations channel shifts materially and quickly which seems
improbable at this juncture, central banks holding a far higher than
neutral nominal rates and progressively shrinking balance sheets will
continue to impart tightening pressure without any additional actual
rate hikes. The bulk of the pain from this unprecedented rate hike cycle
is thus ahead of us in terms of its effect on balance sheets and
general economic growth.
In sum, though there is a path towards a
'Goldilocks landing' that we explored above basis summary of various
market rates and spreads, this is by no means given. There is a very
good chance that the battle against inflation lasts longer, and may
continue to be fought much beyond the peak in policy rates via
continuation of those rates for longer and progressive central bank
balance sheet shrinkage even as nominal growth rates begin to come off
meaningfully. Thus in some way the focus will shift from obsessing on
peak rates to watching for where and with what intensity damage starts
showing up from this unprecedentedly sharp developed market tightening
Needless to say, the longer it takes for the Fed to turn
the more the likelihood of such damage. The risk, as discussed here, is
that markets globally aren't giving enough importance currently to this
period between the end of tightening and the start of easing which may
still require very careful navigation.
China will likely continue
running an economic cycle that provides counterbalance for the rest of
the world, in some sense. Thus Chinese GDP slowed markedly over this
period of stimulus fuelled developed market growth, and is set to
accelerate sharply probably over second half of the next year once the
anticipated disruptions around opening from Covid play themselves out
and the full effect of ongoing policy stimulus starts to get felt. By
then most of developed world in turn would have slowed aggressively.
US slowed less than earlier expected this year owing to an
underestimation probably of the accumulated transfers sitting in
consumer balance sheets, Europe saw meaningful fiscal response to
partly shield the economy from the energy crisis. Apart from central
bank tightening, both these effects are set to fade over the year ahead
thus providing further drag to these economies.
For our own
market, while peak repo rate is in sight (or may be already in place) it
may also have to be held at that level for some time. As noted above,
the world will still likely be a very challenging place which argues for
continued vigilance on macro-economic stability. Fiscal policy will
also have to keep this in mind. While on the one hand, a large part of
additional revenue spending to absorb the acute commodity shock this
year will not recur next year, on the other nominal growth rates will
come off significantly as well.
Alongside, the government will
have to continue with fiscal consolidation in line with the medium term
compression path indicated. Even as the environment will likely still
remain challenging, at least for the first part of the year, we expect a
lot of the macro-economic concerns from this year to abate into the
next. The current account should become more manageable whereas the path
to lower inflation should become clearer.
From the perspective
of investors, this is for the first time in the recent period that more
attention may start to get paid towards liquidity of holdings. This
observation is made more in a generic, global sense but may not be
entirely irrelevant in a local sense as well. Credit spreads have fallen
sharply in India as well owing to a variety of reasons: Balance sheets
have cleaned up in many cases thereby improving credit perception. The
consequent deleveraging has automatically reduced paper supply.
lot of capex that used to happen via public sector entities has been
taken on directly into the centre's budget in order to improve
transparency. This has meant lower issuances by these entities and
higher government bond supply, ceteris paribus. Some part of financing
has shifted from bonds to bank credit reflecting both keener appetite
from the latter to lend as well as heightened market volatility this
Finally, investors have demanded lower liquidity discounts
given the generally easy liquidity environment. Some of these factors
may very well be turning. Bond supply from both banks as well as
companies is picking up. While there is not much of an observable shift
in investors' liquidity preference yet, we expect this to gain traction
over the next year. Also as attention shifts to RBI having to infuse
permanent liquidity down the line, some natural preference may emerge as
well for sovereign assets in one's preferred duration bucket,
especially if credit spreads aren't particularly attractive.
this framework, we continue with our preference for government bonds in
the 3 to 5 year maturity segment as we turn the year. For longer
duration bonds to rally sustainably, market may need visibility on rate
cuts since a starting spread of 100 - 125 bps of 10 year to overnight
rate doesn't leave much scope on its own. Should the developed world
head towards a 'hard landing' scenario, then this could very well be
However, we don't have that visibility yet from our
current vantage point. Also there's a good likelihood of yield curve
steepening in that scenario if the accompanying fiscal compression in
India isn't very meaningful owing to growth concerns. Corporate spreads
have opened at the very front end due to the very large supply of bank
CDs, but are still very modest for longer durations. We expect that
these should start opening up as well as we head deeper into the new
And so another year closes. For some time now one hasn't
quite got the feeling of having quietly closed one door and now gently
turning the knob on the next. Nevertheless there is this door in front
and here's to hoping that you enter in good health, that inside you are
greeted with cheer and embrace, and that the warmth of the room carries
you through the year.
(The author is the Head - Fixed Income, IDFC AMC)
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