Acceleration: A Macro And Bond Update

2/26/2021

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Bond markets around the world are not liking 2021 so far. As an illustration, magnitude of rise in many major markets at the 10 year point is of the order of 35 - 75 bps just in the last couple of months. The latest spike has now finally even registered with growth oriented assets which is, hopefully, the first clear sign that a market driven adjustment phase for bonds may finally be in its last leg. India's bond market rumble first started with the relatively innocuous introduction of the variable reverse repo by the RBI and strengthened further with the excess bond supply thrown in by the budget. However, dwarfing these relatively manageable local developments has been this massive global reflation trade. Looked at in context, the size of India's yield adjustment doesn't look particularly outlier at all. It is therefore this that requires the most analysis and will hence consume most of the ink below:

The Reflation Trade

Let us start with stating the obvious: 2021 was supposed to be the year of reopening, when activity started returning to normal as we finally conquered the virus. While the pent up demand was already visible in goods consumption, services would open fully and global trade would come back roaring again. With all of this would come some return of inflation as well and hence market rates would need to start adjusting. This adjustment would have likely been gradual as most developed market central banks, including most importantly the US Federal Reserve, were assuring a long period of ultra-accommodative policy that would allow labor markets to heal and inflation to not only climb but also compensate for some of the shortfalls of the past few years. However, a new element to this expectation came in early 2021 when political changes in the US allowed for the possibility of a near USD 2 trillion additional fiscal package seeing the light of the day. This has allowed for the reflation trade to find new wings with certain quarters now arguing that US is in the midst of excessive fiscal pump-priming and endangering the return of more inflation than the Fed may desire. Apart from this, yields will also price in some aspect of the higher bond supply although this effect is presumably of lesser relevance in an open international market like the US.

In doing the above, however, the market is largely breaking from the Fed. The Fed leadership continues to focus on the large gaps in employment that still exist and their expectation that inflation, while it will rise on base effects and on services re-opening around the mid of this year, doesn't pose a medium term worry at all. Put another way, and referring to these concepts as they are understood in a day-to-day sense, the Fed is saying that while there will be an acceleration this year, the speed will likely fall back to its previous pace over the medium term. This is against what the market seems to be expecting; that the speed has now changed and will settle at a relatively higher level as compared with the recent few years pre-Covid. This is visible in even long term traded inflation expectations now jumping to comfortably above 2% and around the highest they have been over the past 6- 7 years. All other things constant and after the near term bout of inflation is seen through, it isn't immediately obvious why this should be the case given that the US is now saddled with a very different debt dynamic and an associated presumed further decline in capital productivity. A similar argument can be made with respect to longer term yields: to the extent their rise reflects higher bond supply and near term inflation concerns, that is understandable. However, if the market is now pricing in a higher level of neutral Fed funds rate than before then this notion may be subject to challenges as well in the time ahead.

India's Case

We must state here two somewhat obvious points:

1. It is a given that effective policy rates are too low and have to rise over the next couple of years. Thus to say that RBI will have to start normalizing is stating the obvious and doesn't really contribute much to the debate. The issue rather is the pace and form of this normalization. Our view, as expressed before, is that of a relatively slow process to start with that "will involve more discretionary adjustments to the price of liquidity (for instance by starting to narrow the repo-reverse repo corridor at some point, most likely in the second half of the calendar) rather than the quantity of it. Any substantial policy steps taken to reduce the excess liquidity (automatic lapsing of CRR relaxations, minor MSS issuances, etc are par for the course, in the realm of current expectations, and don't count as substantial policy steps in the current description) will risk disrupting markets and send adverse intent signals" (https://idfcmf.com/article/3568). We have also noted recently that "we fully expect unwind / absorption measures ahead around liquidity (CRR unwinds, term reverse repos, MSS (Market Stabilization Scheme) issuances at some point) to co-exist with twist and outright OMOs (Open Market Operations) to ensure that the effect higher up the curve is blunted" (https://idfcmf.com/article/3766). Both these expectations have been recently affirmed by the RBI governor. The point then when formulating an investment strategy is to fully expect a normalization process ahead that will largely focus on the overnight rate but will also transmit to a somewhat more limited extent to yields up the curve. However given the exceptional steepness in the curve especially at intermediate duration points (5 - 6 years), one can have a scenario of yields rising and still make enough returns over an investment horizon that justifies holding a position (that is, under reasonable assumptions of yield rise, the holding period return may exceed that available on shorter maturity assets that actually match in maturity to that holding horizon). However this thinking fails and cash becomes queen or king, if the pace of change in yields is disruptive over shorter periods as has been the case over the past 2 months. Once this adjustment runs through and the pace of rise in yields normalizes, carry adjusted for duration starts to beat holding cash again. It is also a given that market repricing moves will not happen linearly. Therefore one should almost expect bouts of disruption (although we admit to not having anticipated this severe a bout over the past couple of months). However, what matters is the underlying trend in pace of rise in yields over the medium term isn't so disruptive that carry adjusted for duration and roll down effects stop yielding much. Basis our expectations as outlined above, we continue to believe that this isn't likely to be the case.

2. It is a myth that RBI can draw any credible "line in the sand" with respect to the level of the 10 year bond yield. This is yield curve control (YCC) which is strictly the domain of developed market central banks, and only a handful there as well. YCC implies setting a firm price which then means that the central bank may potentially have to buy unlimited quantities of bonds (and suffer unlimited bloating of its balance sheet) in order to defend this price. This is simply not tenable in an emerging market context. Hence RBI's efforts, including the governor's appeal for an orderly evolution of the yield curve, should be interpreted as the central bank intervening to address the pace of change rather than control the direction of yields. This sits well with our investment thesis as reiterated above and allows for exploiting of yield curve steepness at points where duration versus carry versus roll down effects are most optimal. Thus yields can continue to rise as long as the pace of the rise is broadly modulated by the central bank. Put another way, our investment thesis is comfortable with an assumed speed of rising yields. It is acceleration that becomes a problem, but only if it lasts. We don't believe that it will.

Conclusions

The global reflation trade is completely logical in its direction of pricing. Some acceleration in the trend may also have been justifiable as the size of US fiscal response picked up. However, it is still likely that bulk of this adjustment may have run its course for now and the repricing now falls back to a more sustainable pace. There may even be givebacks from time to time as market adjusts to a most likely pace of change. There is also an element of longer term repricing here as for example to US inflation expectations and hence the neutral Fed funds rate. This will unlikely be called into question while we are in the current bout of reflation. The key test to these will come when the pent up phase is done and we have a "cleaner" set of data and drivers to work with. As for our local bond markets while our ongoing cyclical recovery and eventual improvement in perceived credit profile may argue for a gradual reduction in yield spreads over developed markets over time (as what happened in the pre-2008 period) which may reduce the impact of say US yield changes into ours, the near term correlations may nevertheless be strong enough. However, as explained above, it is really the pace of change in bond yields that matters. When yield curves are this steep, one can no longer think only in terms of being "long or not". Additionally the traditional way of thinking about risk reduction through moving to short duration money market assets may not work in an environment where it is actually the overnight rate that needs to shoulder the bulk of the readjustment ahead and hence assets most closely priced off the overnight rate may be at the most risk of readjusting. It is for this reason that some amount of "bar-belling" alongside exposure to quality roll down products may make sense (https://idfcmf.com/article/3766).

Our recent underperformance in some of our non-positional medium term and active duration mandates is attributable to 3 factors:

We have been reluctant to run cash given the steep carry loss involved. This has hurt as the rapid pace of change in yield has negated the carry adjusted for duration principle we have been following. Put another way, the duration loss even in moderate maturity bonds has been so severe over this short time frame that it has more than negated the excess carry earned over cash. However, as the pace of change stabilizes (even as yields can still go up) this will likely restart thereby restoring the outperformance of this strategy over cash.

The RBI has largely tried to hold up the 10 year point which has led to extreme underperformance of shorter maturity bonds versus the 10 year. This is somewhat ironical since the overnight rate as well as near term money market instruments have remained very well anchored. This has now lead to approximately 6 year government bonds (our preferred overweight currently) to almost within 10 bps of the old 10 year bond.

Most of the duration in these funds is coming from government bonds that have repriced the fastest over the past few weeks, as they often do. This has led to further shrinking of corporate bond spreads in the 5 - 6 year segment over government bonds, and of illiquid lower rated asset spreads over quality corporate bonds. As always, however, these are temporary factors and will adjust overtime and the unit of interest rate risk remains the duration that a fund carries.

Source: IANS

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