DSP Converse - August 2023

Our Framework

Takeaway:
No major driver for yields. We are bullish on account of attractive valuations.

CAD – Current Account Deficit; BoP – Balance of Payment; SLR – Statutory Liquidity Ratio; SDL – State Development Loans; RBI: Reserve Bank of India; G-Sec: Government Securities; OMO: Open Market Operation; FPI: Foreign Portfolio Investment; FOMC: Federal Open Market Committee; I-CRR: Incremental Cash Reserve Ratio; PMI: Purchasing Managers’ Index; GST: Goods and Services Tax; NSSF: National Small Savings Fund

We are bullish

Why? Because of Valuations!

Markets are pricing in a lot of negativity

Yet, inconclusive evidence to justify fall in yields. Or rise in yields.

Any positive news may cause a sharper rally, than a sell-off due to negative news

View Summary: Bullish

Our Strategy: We turn long in our active funds

10Y Indian G-sec yields have risen to ~7.20: upper end of our expected range, tracking US yields (and may continue in future).

Even though the US labor, CPI and services data have weakened, its lower than the expectations. Unless US economic data softens significantly, rate cuts won’t be expected. Until then yields won’t fall.

On the other hand, risks of FED being hawkish are real – yet tail risks. Data is softening, previous rate hikes are still percolating in the economy – and higher rates for longer can lead to black swan events – which no one can predict.

While Indian CPI has come at ~7.4%, it will not lead to a trend. As we always mention, in India the volatility of supply driven CPI can only create noise – not trend. In few months as tomatoes and vegetable prices fall naturally – so will CPI. Markets (and RBI) should look right through it – though there will be noise.

For money markets investment: We will keep adding duration as and when the spreads look attractive. The surplus liquidity and matched demand-supply will keep a cap on rates, despite CRR hike.

• Reasons for our view

  1. Data isn’t a one-way street – so why are markets?: US data is softening, but not fast enough. Indian CPI has risen but its transient. Why should central banks take strong rate actions? In such times, recent yield spike makes valuations attractive.
  2. India term premium is still high, especially considering the fiscal strength. With benign rate outlook, current yields are attractive.

• Risks to our view

  1. Are we running a hope trade and biases? Are we “hoping” for data to weaken – when we ourselves mention that data is not looking weak. We have ensured that we are not having a confirmation bias – we look at data from both sides of the spectrum.
  2. Tight stop loss: We are aware that we are digressing from our framework. Frameworks are to be followed– but digression is needed at times. Digression means more responsibility: (i) one needs to be aware of why and when we digress, and (ii) one needs to be disciplined to exit such trades if they do not work - not wait it out. We have followed first part – and wont hesitate to follow the second part.

G-Sec: Government Securities; CPI: Consumer Price Inflation; FED: Federal Reserve; RBI: Reserve Bank of India; CRR: Cash Reserve Ratio

Let’s revisit our rates call trajectory

Source – Bloomberg

To start with,
Recap of events since last release.

RBI continued with a PAUSE

With caution around inflation

India CPI at 15m high (led by veggies)

FED raised rates by 25bps

US CPI and labor market show signs of cooling off – but not enough

RBI continued with a PAUSE

• Rate Action

  • Unanimously voted to keep key policy rates unchanged at 6.5%

• Stance

  • 5 of 6 members voted for remaining focused on withdrawal of accommodation

• Inflation

  • Revised higher by 30bps to 5.4% for FY24
    • X Revised up sharply for Q2 from 5.2% to 6.2%
    • - Spike in vegetable prices to exert sizeable upside pressures on near-term headline inflation trajectory (although likely to correct with fresh market arrivals)
    • X Impact of uneven rainfall distribution warrants careful monitoring
    • X Crude oil prices have firmed up amidst production cuts

• Growth

  • GDP forecast retained at 6.5% for FY24
    • ✓ Recovery in kharif sowing and rural incomes, buoyancy in services and consumer optimism to support consumption
    • X Weak external demand and geo-political tensions remain a concern

RBI: Reserve Bank of India; GDP: Gross Domestic Product

US Data continues to soften: but markets want more

Takeaway:
Services sector being the major contributor to employment and inflation, any further softening to provide a tailwind

Source – Bloomberg NFP: Non Farm Payroll, PMI: Purchasing Managers’ Index; CPI: Consumer Price Inflation

Now our framework

And

What we track

Our Framework

Takeaway:
No major driver for yields. We are bullish on account of attractive valuations.

CAD – Current Account Deficit; BoP – Balance of Payment; SLR – Statutory Liquidity Ratio; SDL – State Development Loans; RBI: Reserve Bank of India; G-Sec: Government Securities; OMO: Open Market Operation; FPI: Foreign Portfolio Investment; FOMC: Federal Open Market Committee; I-CRR: Incremental Cash Reserve Ratio; PMI: Purchasing Managers’ Index; GST: Goods and Services Tax; NSSF: National Small Savings Fund

RBI commentary:

“Stable Domestic Macros”

“Vegetable price led inflation surge”

“Core print of sub 5% provides comfort”

“MPC can look through high inflation print

…caused by such shocks”

Headline inflation at 15m high, Core CPI falls – don’t fret!

Takeaway:
Caution around inflation. Rules out any rate cuts for now.

Source – Bloomberg, RBI, Internal CPI: Consumer Price Inflation; RBI: Reserve Bank of India; IGB: India Government Bond

El Nino a very high possibility albeit may not be a major risk to inflation

Takeaway:
El Nino risks remain, however, not a major risk to inflation

Source – FCI, Australian Govt BoM, NFSM

India’s

growth remains resilient

across high and low frequency data.

Will global slowdown test domestic growth?

Takeaway:
Domestic growth seems to be resilient so far despite global slowdown fears

Source – Bloomberg GDP: Gross Domestic Product; PMI: Purchasing Managers’ Index; GST: Goods and Service Tax; IGB: India Government Bond; Mfg: Manufacturing; MSME – Micro, Small & Medium Enterprises; RBI: Reserve Bank of India

What made RBI Pause?

What drives pauses: Series of hygiene factors - Neutral

Takeaway:
So far, there is no conclusive reasons for any rate action by RBI.

Source – Bloomberg RBI: Reserve Bank of India; US FED: US Federal Reserve; BoP – Balance of Payment; CPI: Consumer Price Inflation; EM: Emerging Markets

What makes RBI Hike?

FX and FED (primarily), and CPI (hardly).

Although hike unlikely, as the FX reserves have increased significantly

Did you know – when our Fx reserves dip, RBI hikes

Takeaway:
FX Reserves have increased significantly, and there is enough ammunition to protect rupee

Source – Bloomberg RBI: Reserve Bank of India; IMF: International Monetary Fund; US FED: US Federal Reserve; FX: Forex; CPI: Consumer Price Inflation

Data has worsened since last DSP Converse

Rupee is higher, CPI is higher, US data weakened (although less than expected)

We reiterate what we said last time:

“tail risks remain from any large FOMC action”

Let’s turn to Fiscal policy

Generally, it drives the long bond yields

It is reflected in demand/supply mismatch.

Fiscal policy is less of a driver right now – though election risks will precipitate in next few months

Only a small part of bond buyers are
discretionary buyers

They drive yields

Supply fluctuation is borne by these buyers

Gsec market is still driven by lumpy institutions

Takeaway:
Increase in supply impacts the discretionary buying. Banks excess holding, passive buyers have been absorbing the supply

Source – DBIE LCR – Liquidity Coverage Ratio; SDL – State Development Loans; PF – Provident Funds; PD – Primary Dealerships; MF – Mutual Funds; FPI – Foreign Portfolio Investors; FI – Financial Institutions; RBI: Reserve Bank of India; G-Sec: Government Securities

Comfortable supply/demand dynamics for FY24

But it will be bumpy ride

Last 4 months demand/supply has been rosy
(latent purchases, low SDL issuances)

Comfortable SDL demand-supply metrics

Takeaway:
SDL supply may remain muted in FY24

Source – DBIE, RBI T-bill: Treasury Bill; SDL: State Development Loans

Banks have already bought significantly!

Takeaway:
Banks’ probably lesser demand in future to be negative.

Source – Bloomberg, DBIE, Internal OMO – Open Market Operations, SLR – Statutory Liquidity Ratio; G-Sec – Government Securities; RBI: Reserve Bank of India; FRA: Forward Rate Agreement; TRS: Total Return Swap

Large liquidity overhang continues

Takeaway:
Liquidity expected to remain adequate

Source – Bloomberg, RBI: Reserve Bank of India; CIC: Currency in Circulation

RBI’s intent to anchor overnight rates at REPO

• RBI introduced incremental CRR (I-CRR) of 10%

  • This applies to incremental NDTL between 19^th May to 28^th Jul
  • Expected to suck-out liquidity of around 1.1tn
  • To be reviewed on 8^th Sep or earlier
  • Expected to have a temporary impact on liquidity
    
    • ✓ However, overnight rates to trade closer to REPO

• Background

  • Excessive liquidity poses risk to price and financial stability
  • Banks were not tendering enough in VRRR auctions which the RBI was using to moderate liquidity
  • Overnight rates were hovering at SDF levels

Takeaway:
RBI to keep overnight rates anchored at or around REPO levels

Source – RBI, Internal I-CRR: Incremental Cash Reserve Ratio; MM: Money Market; NDTL: Net Demand and Time Liabilities; SDF: Standing Deposit Facility; VRRR: Variable Reverse Repo Rate; RBI: Reserve Bank of India

How much is the excess supply

• Excess supply can be matched

  • ✓ G-sec supply is higher only by 7% over FY23, however demand is expected to rise much more
  • ✓ Continuing strong demand from long end investors like EPFO, Insurance and PFs
  • ✓ NSSF deposits at ₹ 1.94tn (till June) vs ₹ 1.34tn (till Jun’22)

Takeaway:
Estimated excess supply of ₹ 1.06 tn is not very significant. NPS may grow at 20% (we have taken 13%), Banks may sustain current SLR ratio of 30.5% (we have taken 30%)

Source – Internal, CGA G-Sec: Government Securities; OMO: Open Market Operation; RBI: Reserve Bank of India; FPI: Foreign Portfolio Investment; NPS: National Pension System; MF: Mutual Fund; SDL: State Development Loans; SLR: Statutory Liquidity Ratio; PF: Provident Fund; EPFO: Employees’ Provident Fund Organisation; NSSF: National Small Savings Fund

In last DSP Converse we said that US yields may
not drive Indian

No more

With domestic data being neutral and
directionless…

We will dance to the tune of US yields.

With less beta, but still correlated

Indian yields – Dancing to the tune of US Yields

Takeaway:
With domestic data being on the neutral side, India yields tracking US yields

Source – Bloomberg, Internal Fed: Federal Reserve; CPI: Consumer Price Inflation; RBI: Reserve Bank of India; IGB: India Government Bond; FOMC: Federal Open Market Committee; UST: US Treasury

US Yield Curve and WIRP

• US yield curve has bear steepened

  • No major change in expectation of rate action by the FED
  • However, longer end of the yield curve has moved up
    
    • Reflects a “higher for longer” view
    • That inflation will only gradually decline, but may be higher than the “2%” in past
    • Excess US fiscal supply, and demand constrained as Quantitative Tightening on

Takeaway:
US yield curve impacted by higher for longer and demand-supply issues

Source – Bloomberg

What else

that

can’t be bunched up

Supply-demand and liquidity: Key driver for short end yields

• Divergence between credit and deposit growth continues
• Demand supply seems to be well-matched
• I-CRR (RBI’s intent of anchoring overnight rates to REPO) may cause liquidity disruptions
• Expect a volatility of 10-15bps

Source – Bloomberg, Internal CD: Certificate of Deposits; RBI: Reserve Bank of India; T-bill: Treasury Bill, I-CRR: Incremental Cash Reserve Ratio

Term premia: It’s a BUY!

• This slide is the reason why we have long bias – Valuations

  • So far, every point in our presentation was neutral or hawkish…

• …But that bad news has been priced in

• Even if RBI hikes (unlikely and even then probably last hike)…

  • The spread with 5-Year bond is 50bp!
  • Take away covid (hikes were expected) and reverse demonetization: currently the spread is neutral…
  • …then price in future rate cuts in FY25 (as in 2014-2017 and 2019) – suddenly bonds are a good buy

• Since last DSP converse, data has worsened – so have yields. The odds are in favor.

Takeaway:
India term premium is still high.

Source – Bloomberg RBI: Reserve Bank of India

DSP FI Framework checklist

DSP Duration decision: Negative data priced in. Valuation attractive

The chart shows how much expected yield fall/rise is already priced in the current curve.

Large gap between the current yield and forward yield shows that yield change is priced in – and thus yield change will not give capital gain/loss.

Similarly small gap means that the market is not pricing change in yields.

• Market expects yield curve to remain flat

  • The future rate curve is close to current yield curve, expecting yields to remain range bound

Source – Bloomberg; as on 17/Aug/23

Done with our market view framework?

Now

Our Portfolio creation framework

DSP Portfolio Creation: Multi-step process

DSP Fixed Income Funds follow a defined methodology for fund portfolio construction

• We apply market risk filter which can help the Fund Managers not to take extreme risks. Thus, Value at Risk is limited by ensuring the positions are balanced.

Investment approach / framework/ strategy mentioned herein is currently followed & same may change in future depending on market conditions & other factors.

DSP Credit Investment Process – Better Safe, than Sorry!

DSP Asset Allocation: Corporate bonds vs. Sovereign Bonds

Takeaway:
Corporate bond spreads near their long term average, spread curve flat.

Source – Bloomberg, CCIL, Internal PSU: Public Sector Undertaking, NBFC: Non-Bank Financial Companies

Key Risks associated with investing in Fixed Income Schemes

Interest Rate Risk - When interest rates rise, bond prices fall, meaning the bonds you hold lose value. Interest rate movements are the major cause of price volatility in bond markets.

Credit risk - If you invest in corporate bonds, you take on credit risk in addition to interest rate risk. Credit risk is the possibility that an issuer could default on its debt obligation. If this happens, the investor may not receive the full value of their principal investment.

Market Liquidity risk - - Liquidity risk is the chance that an investor might want to sell a fixed income asset, but they’re unable to find a buyer.

Re-investment Risk - If the bonds are callable, the bond issuer reserves the right to “call” the bond before maturity and pay off the debt. That can lead to reinvestment risk especially in a falling interest rate scenario.

Rating Migration Risk - - If the credit rating agencies lower their ratings on a bond, the price of those bonds will fall.

Other Risks
Risk associated with

• floating rate securities
• derivatives
• transaction in units through stock exchange Mechanism
• investments in Securitized Assets
• Overseas Investments
• Real Estate Investment Trust (REIT) and Infrastructure Investment Trust (InvIT)
• investments in repo of corporate debt securities
• Imperfect Hedging using Interest Rate Futures
• investments in Perpetual Debt Instrument (PDI)