As expected the monetary policy review was status quo on policy stance and rates. However, there was a lot under the hood that was very hawkish indeed.
Assessment first — no major surprises here as the domestic growth remains resilient, with risks largely from uneven monsoons and the external side. On inflation, unwind in the recent surge in vegetable prices as well as the relatively well behaved core inflation trends are welcomed.
The latter has softened by 140 bps since January to 4.9 per cent now, even as the Governor notes further disinflation in the core component as being critical for price stability.
Importantly, household inflation expectations are in single digits for the first time since the pandemic. Nevertheless, there are risks from certain food items on account of lower Kharif sowing, El Nino conditions, global food and energy prices, and from global financial market volatility.
The hawkish part
There was a reiteration that CPI target is 4 per cent and not 2 to 6 per cent. But this has been done before and the bond market took it in its stride. What turned out to be unpalatable for the bond market is the Governor saying that RBI may resort to OMO bond sales for liquidity management if the need should arise.
In the post policy conference, he further clarified that though there is no calendar being given for OMO sales, whenever it happens, it will be done via the auction route. This is different from the OMO sales that RBI has lately been conducting via the NDS OM platform. The latter have been for smaller amounts and have not been market moving.
However, explicit sales via the auction route are a different cup of tea. Also, while nothing has been announced thus far the Governor has effectively unleashed a long sword of uncertainty on the market’s head. There are certain aspects of the evolution of RBI’s liquidity framework that we assess below.
Our understanding has been that RBI’s liquidity model was anchored around targetting weighted average call rate using the VRRR as the primary tool for liquidity management. Thus so long as this was being achieved the actual quantity of liquidity in the system wouldn’t matter as much.
The usage of the temporary ICRR tool undertaken in the previous policy seemed to stem from RBI’s frustration that banks’ offtake of 14 day VRRR seemed patchy. To be fair, though, there were explicit comments then about the potential damage that may arise from excess liquidity.
Even so, the understanding mostly was that preference was for shorter term tools rather than permanent measures as far as liquidity is considered. Thus apart from VRRR, one was hearing about RBI conducting short tenor sell-buy swaps in dollar-rupee as well. The recent OMO sales via NDSOM screen had been quite modest.
However, the intention now to step OMO sales leads to some questions. One, why was the ICRR tool introduced with such an explicit guidance on its unwind? Why was it not kept open ended to be unwound as and when liquidity conditions permitted it? The reason we ask these is as follows: As per our estimates core system liquidity is of the order of INR 3,25,000 crores post the I-CRR unwind. However, currency in circulation is expected to rise by INR 225,000 to 250,000 crores by end of March 24, as per normal seasonal trends.
Further, the balance of payment has been quite healthy over the first half of the year and is unlikely to be the same over the rest of the year.
While this is speculative and difficult to model, but already RBI’s dollar sales have picked up. The point we are making is that, in all likelihood there is no reason at all to take permanent measures on liquidity mop up given that most of the core liquidity surplus is already poised to vanish by the financial year end.
The bother really is the time it takes for this to happen and that is why the temporary measures made perfect sense and the permanent measures (like OMO sales) don’t.
The other argument is that, despite denying it publicly, RBI actually wants yields to adjust higher, probably reflecting the rise in global bond yields. We are less inclined to go with this argument since at best it is a slippery slope to manage for the central bank.
Market view
The developments today post a near term challenge to our overweight position in 9 to 14 year bonds in our active duration funds. Our fundamental premise here was a more favorable demand – supply situation basis both the upcoming FPI inflows as well as due to the drop in net government bond supply starting this quarter.
However, now RBI emerges a new supplier of government bonds. While there is no explicit calendar for this, as mentioned before a long sword hangs now that such OMOs can be announced any day. This is especially so since the market understands that the best of liquidity is likely over October-December quarter.
Core liquidity may shrink enough by then (for reasons mentioned above) for RBI to not want to persist with OMOs from the next quarter. Thus the risk of this additional supply is more near term, and this may weigh more on the minds of market participants.
While the move today is painful to our positioning, our view for now is to persist with the more medium term in mind.
Even accounting for some OMO sales net supply for the rest of the year will still be substantially lower than for the first half of the year gone by. Thus we don’t expect demand supply to be deeply out of skew unless the OMO sales are very large (not the base case).
We don’t know the amount, frequency, or tenor distribution of the OMOs. If as an example, RBI chooses to focus more on very short tenor bonds then the market needn’t have to worry as much eventually as it is worrying today. Put another way, the uncertainty regarding this announcement is at its highest currently and that is getting reflected in the free fall in bond prices at the time of writing.
This is more a macro positive and doesn’t pertain as much to the immediate issue. One of the risks to the bond view we had mentioned earlier is that of substantial fiscal slippage. This was basis fiscal data till July 23. However, August data has seen a surge in tax revenues and has been a bit of a game changer.
As can be seen, the recovery is remarkable and substantially brings down the run rate required for the rest of the year. This substantially reduces the chances of any meaningful fiscal slippages.
Conclusion
The risk so far one was contending with for a long bond view was chiefly from US yields. The potential OMO announcement has now introduced a local risk. Given that this was unanticipated and remains uncertain in contours, the reaction for the time being has been large from market participants. However, the underlying framework remains broadly the same.
Eventually, the local trigger will likely count as a small blip in some sense. The US bond yields are a more persistent variable to monitor in the near term but for reasons discussed before, we think it highly likely that these stabilise as well in the medium term.
We continue with our overweight stance in 9 to 14 year government bonds in active duration bond and gilt funds. Short and medium duration funds continue overweight 3 to 6 year with overweight on government bonds versus corporate bonds wherever the mandate allows for it.
The writer is Head of Fixed Income at Bandhan AMC
20231006142081
