March 26, 2009

The Indian version of yield-curve conundrum

Alan Greenspan coined a term called ‘yield curve conundrum’ to describe what he thought was an anomaly in the US treasury market then. As the Federal Reserve with Greenspan at the helm of affairs kept raising the Fed rate, long term rates ironically kept low resulting in a flat to inverted yield curve. The impending slowdown in US was one key fundamental reason for the long term rates to remain relatively low. Yet, the generic long term demand for US treasuries by global central banks and long term liability managers kept the long term rates subdued despite the increasing inflationary pressures in the economy. For a period too long, the long term rates seemed to react to anything but events and policies mushrooming in US.

A similar conundrum, albeit differently, is what we are experiencing in the Indian bond market for some time now. Reacting to a domestic slowdown resulting in contraction of output and falling prices, the Reserve Bank of India has rightly been easing its monetary clutches in the economy by cutting all rates it could – CRR, Repo, Reverse Repo and SLR. Though the central bank embarked on the easing during mid-2008, it intensified the rate cuts towards the end of CY2008. After an initial logical fall in the long term yields, we have experienced a reversal in the trend during the last few weeks starting mid-January 2009. The key reason for this conundrum is the supply of long term bonds to fund the accumulating fiscal deficit. An already fragile bond market has depicted its non-willingness to keep absorbing higher supply without paying lesser price for them. Yield, henceforth, have been moving northwards. With the supply calendar looking to increase with coming months, where are we headed in terms of interest rates in the system?

For one, RBI will continue to ease benchmark policy rates against a very comfortable backdrop of near-zero WPI based inflation and contracting industrial output. Considering the most likely scenario of WPI inflation remaining at an average of -1% from now to the end of FY2010 (conservative estimate), and a real interest rate of not more than 2%-3% to tackle an extremely subdued growth outlook, the nominal benchmark rates will have to be cut to levels of 2% or less quite soon. With liquidity conditions expected to keep positive on a consistent basis through CRR cuts/OMO by RBI, the effective benchmark policy rate would continue to be the Reverse Repo rate. Thus one could expect at least 150bps of easing over the next few months.

Secondly, yields would be supported by comfortable liquidity in the money market. Fiscal spending, OMO and possible cuts in CRR will help the liquidity remain the positive regime over the next many months. It seems very unlikely that bonds would be sold to create liquidity for meeting credit demands in the economy.

Thirdly, generic demand from insurance companies, banks, mutual funds, and importantly FIIs will help absorb the incremental demand in FY2010. With rupee trading at 50-plus levels against US Dollar in the exchange market, a comfortable stance by the RBI to help currency appreciation will favour the foreign investors chasing risk free yields in the uncertain global investment regime. It seems highly likely that RBI will intervene more aggressively starting April to push USD/INR rates lower after FII buying into bonds. Weakening USD globally (backed by huge monetization of deficit by US government) and revival in investment flows will help the rupee appreciation cause too in favour of investing FIIs.

Fourthly, RBI’s holdings in outstanding government bonds have been steadily rising over the last 12 months. This trend will most likely continue and rather intensify as we move ahead. RBI’s holdings as a percentage of total outstanding has steadily increased from 4.3% as at December 2007 to 5.8% as at the end of September 2008.

Despite a heave supply side pressure on yields, it still looks likely that the long term yields would ease in the coming months responding to a temporary statistics-induced deflation and easing benchmark rates.

As a probable move in the near term, RBI could consider introducing a ceiling on the Reverse Repo absorptions under LAF to effectively bring in a zero interest rate policy without officially cutting interest rates. Subdued money market rates will help the yields ease helping the cause of broader interest rate regime in the economy.

We will have to wait for the April policy to see if RBI might want to embark on a dynamic path like this to manage the monetary objectives.

March 11, 2009

Can we read something here?

An interesting chart that I happened to stumble upon. Just as a background, equity market price corrections (reversal from a bull phase to a bear phase) must technically clear two parameters - the test of time and the test of price erosion. Now look at the chart below (for larger size, click on the image):

We seem to have fulfilled at least the price correction parameter. And time corrections could be evaded by incremental positive events and data flows. Looking at the latest set of data in US (I will elaborate on this part separately in a post later), we might well have seen the worst in US.

Ofcourse the chart reflects Dow. But then, hasn't the recent crash educated us already that India and US never de-coupled in a strict sense?

February 11, 2009

More bond supply to chew

Governments all across the world, including US and India, are all out to do everything they can (and more) to save growth. Between US and India, the difference just being that the US Fed Reserve Chairman and their Finance Secretary has to officially justify and testify what they are upto. Back home in India, we get to know about what has already been done. No questions asked. More like, no one to ask.

If we are unhappy about what is being done, we sell stocks and bonds. Quite simple. And so bonds have been bearing the brunt of these growth-saving-efforts. Government wants market to fund it another Rs.46,000crores over the next 6-8 weeks. Phew.. So much to absorb, literally. With this, the total amount of auctions has reached Rs.231,000crs (gross) for the current fiscal. Out of these, banks alone have bought Rs.164,000crs. Add the demand from insurance companies, primary dealers and mutual funds, fact is the supply might be short of the requirement!

Last few weeks, the yields have been surging, prices dropping. Does it hit my stop-loss as a bond buyer? Not really. I would look to add more. Underlying bullish trend still remains firm, the rally just being postponed for the time being.

Let's see why. Excessive supply of bonds is negative for the market in two ways. Firstly, the liquidity angle. Supply of bonds equals absorption of system liquidity. But only temporarily. Government is borrowing BECAUSE it wants to spend. So money has to flow back sooner rather than later. Also, if there is even a short term liquidity mismatch, RBI will step in swiftly to infuse money by buying more MSS bonds or cutting CRR or if need be, both.

Coming to the second impact, that of higher supply of bonds due to auctions. That is, demand being equal higher supply can be absorbed only by reducing prices. If you look beyond the obvious, the long and short of it is that MSS bonds are being replaced by Non-MSS bonds in the investors' portfolio. There is no NET increase in the stock of bonds available really. That is why buyers won't really feel the weight of auctions in these times.

To put numbers into this statement, the total amount of MSS bonds bought back during Oct. 2008 till date is Rs.65,040 crs. Total auctions during the same period was Rs.86,230 crores. Redemptions during the period was Rs.11,450crs. The net increase in outstanding bonds in the market, hence, is only Rs.9,740crs. During the same period, the net accretion to banking system's deposits was Rs.187,940crs. Incremental SLR demand on this comes to Rs.45,105crs. Now, compare 45,105 with 9,740 and you will know why the yields are so lower than what they were in October 2008. The demand side from other generic buyers apart from banks have not been considered in my calculations. (For basic readers of this blog, hope the math is not very confusing)

Point is, me thinks this situation will continue. Meaning, the pain of incremental supply is not really a lot. Look at the armory with the RBI. CRR is at 5%, can be cut to 3% without any hitch. That's about Rs.72,000crs of liquidity. Outstanding MSS is Rs.108,764crs. Add both, and there's a lot of money to be released if need be. Don't forget, we are already sitting on a surplus liquidity of Rs.43,000crs approx.

Now, if interest rates still have to come down by 150-200bps over the next few months (my views expressed in earlier posts still hold good), yields can only go one way - DOWN. And so, I'll look to buy more gilts through my favorite ICICI Pru Gilt Fund.

January 31, 2009

That's what is a meltdown!

The picture says it all. One of the biggest lessons of the subprime fiasco is that all big boys with their extra-ordinarily smart people can ALL go wrong AT THE SAME TIME. The next time when you hear of the NEXT BIG THING that everyone's gung-ho about, beware. The majority need not be always right!

Click on the image for a larger view.

January 22, 2009

Inflation rise, bonds fall - looking ahead to the policy

YoY WPI based inflation has risen to 5.60%, thanks to truckers' strike during the week under review. Primary articles and food component of manufactured products have contributed to the price rise.

Yet, I do noe see any real deviation from the underlying trend. It is a matter of weeks before we see inflation figures in the sub-4% territory.

Bond prices have corrected this week, being the last before the key policy announcement next Tuesday. Lesser section of the market is nor expecting any rate cuts by RBI this time in the policy. I am still a part of this minority. From the Q3FY09 results that have already been announced by corporates, the slowdown is clearly evident in India Inc. Sans a few names, most have spelled out disappointing numbers. I would expect RBI to remain pre-emptive in estimating the impact of slowdown and trend in falling inflation. A 50bps cut in both the Reverse Repo and Repo Rate will be apt given the current juncture. Credit needs to flow at a faster pace to the real sector and fairly quickly. The global factors are not showing any signs of a revival any time soon and it is upto the domestic think-tank to moderate the pace of de-growth in economy.

Apart from rate related measures, expect easing in risk weightages and provisioning norms. With liquidity at almost 56K crores surplus, a CRR cute looks improbable.

Disclosure: I am invested in gilts through a mutual fund scheme.

January 13, 2009

An entry point for getting into bonds

Last few months have been extremely conducive for traders, including day traders and jobbers. Not just in equities, but even in currencies and commodities. With the introduction of currency futures in September 2008, punting in that space have become fairly convenient too. However as a retail trader, bonds are still inaccesible to me for direct trading. Ironically, my best trading views and most of my high conviction ideas are in that space. Anyways, trading in equity derivatives and currencies have been fun and excitingly profitable. I am not a commodities person. As of now!

Whilst I am incapable of trading in bonds directly due to logistical issues including big lot sizes, I can translate my views into money through open-ended gilt schemes. I have been bullish on bonds since September 2008. We have already seen a super-rally in bonds. The benchmark 10-year yield has eased from 9.50%+ levels to sub-5.25% levels over the last 3-4 months. Despite that, there is still some juice left in bonds, more so on a relative basis vis-a-vis equities. The 10-year yield is currently trading close to 5.70% level. The market witnessed a huge bout of correction and profit-booking during the first few trading sessions of 2009 till yesterday. The primary trigger for the sell-off was the Rs.50,000 crores fresh borrowing announced by the government for the last three months of the current fiscal. That, and the fact that we had rallied a lot (and pre-maturely perhaps), resulted in a correction of a good 90bps over the last one week. 1% change in yield of 10-year government bond is equivalent to approximately 7.10% change in the bond price.

Where do we stand now? Let us look at the negatives first. Firstly, higher supply is pain for bonds. Secondly, the generic demand in the form of SLR might be moderating with lower deposit growth. Bank deposits are growing at 21% for few fortnights now, lower than the 25%+ that we have seen last year.

Among the positives:

The biggest driver will be falling inflation. With fuel prices expected to be cut again in a couple of weeks, we could see inflation falling more starkly. At a time when the policy makers are trying to revive growth, real interest rates cannot be higher than 2%-3%. Year-on-year price change will soon be negative. So, we will see the overnight Reverse Repo rates and CRR cut by at least 75bps-100bps pretty soon. Liquidity remaning in the positive regime and call rates at sub-4%, 10-year yield cannot stay at these levels for very long. The 10-year over call rate spread should be at a high of 50bps-75bps at the peak of the markets. So if call rates do trade at 3.5%, 10-year yield can surely see the sub-4.50% levels.

Corporate results and industrial/manufacturing growth has few more quarters before showing signs of strength.

Net net, there exists not many reasons to keep yields high. At current levels, one could buy bonds and expect atleast 10% returns in a time-frame of 4-6 months, conservatively. That's 20% per annum! Not bad at all.

About my portfolio: I have invested in the ICICI Pru Gilt Fund - Investment Plan. With an average maturity of 16.66 years, modified duration of 9.15 years and backed by a decent corpus of 716crs (as on 31st Dec. 2008 - sourced from their fact sheet), it is perhaps the best bet for the above-mentioned view.

Happy investing!

January 02, 2009

Stimulus package: Version 2

Barely a couple of days after I wrote that I see more rate cuts coming from the RBI, we get 100bps cut each in Reverse Repo and Repo rate, coupled with a 50bps cut in Cash Reserve Ratio. These rates stand at 4%, 5.5% and 5% respectively.

The government, from its side, has announced a number of measures as a part of its second and more importantly, last package for this fiscal. You can read the details here. With national elections expected to be held during May/June 2009, I do not expect any more fiscal measures effectively before the end of June 2009. Plus, if there is a change in government, the new team will take few more months to take any concrete actions. My fear is, by that time the damage in the economy would have been done.

Barring few specific measures like cuts in excise duties, nothing else in the fiscal package looks likely to impact the economy positively enough. With the demand side of the equation almost in a standstill in key sectors, a lot of these measures merely gives the producer class some breathing space before the inevitable happens. And that is cut in production and prices leading to cut in shops and reduction in worforce. We have already seen this in few sectors. More will come our way this year.

The fiscal package includes some shockers. Increasing the FII limit for investments in corporate bonds! Are we kidding? Considering what the spreads have been for Indian corporate papers in Euro markets, I find it improbable that they will absorb similar issuances in Indian soil. Similarly, raising the ECB interest ceiling for select integrated township developers also seems a blunt measure.

Am I, as a consumer, going to spend more based on this fiscal package? No. And that is the problem.

I am glad that the monetary measures have come again. The rate cuts I expected have come a little earlier than my sense of timing. That leads me to believe that we have to see more. At least 50bps more on all the three key rates before the end of this fiscal. Of course, considering what already has been seen, further 50bps is just nominal. But it makes a lot of difference for bond yields. 10-year yield falling below 5% on Monday is a given. 4.50% is the next level I would be watching, but not quite soon. Higher spending means higher borrowing. The supply side for bonds will temper the rally to some extent. Yet, do not expect anything to prevent 4.50% to be traded over the next few weeks.

What next? Expect a series of rate cuts by banks. Deposit rates first, followed by lending rates. They would hope that the consumers will return to borrow soon. I have my doubts. When your job is in danger, you don't think of adding a liability (for an asset) to your personal balance sheet, do you?. Sentiment is the key here too, like in markets. It takes a lot to convince a terror victim that the world is a very safe place!