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DSP Converse - July 2023

Our Framework

Monetary & Fiscal Policy

Takeaway:
We are neutral overall. We wait for weaker data to change our view

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; B/S: Balance Sheet; FOMC: Federal Open Market Committee; CRR: Cash Reserve Ratio; PMI: Purchasing Managers’ Index; GST: Goods and Services Tax

We remain Neutral.

Macro-data has shown softening trend in past month in AE.

We remain invested, but at neutral levels.

Markets will remain volatile – but we still do not see a clear trend – though there is a bullish bias.

Our View – Summary (Repeat of last month)

Our Strategy: Be invested – neither underweight, nor overweight

10Y Indian Gsec yields have increased ~10 bps to 7.10%. For a rally, markets need to “price in” future rate cuts. But the US labor, CPI and services data have remained robust. Unless US (or India) economic data softens, rate cuts won’t be expected. Until then yields won’t fall.

In such a scenario, currently we prefer being neutral. If underlying macro data does not change, but markets rally on sentiment – we will sell and go underweight. If markets sell on panic, we will buy .

But if the macro data weakens, we will add duration without hesitation.

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.


  • Reasons for our view

    1. Data just isn’t weakening: The US data remains sticky. Indian inflation has softened- but this seems transient. Thus, why should central banks cut rates? But markets have priced in rate cuts.
    2. Demand-Supply has turned neutral: Banks SLR holding has increased to high levels. The Insurance/PF/EPFO will continue to buy. SDL issuance remain neutral.

  • Risks to our view

    1. Date dependency: Continued strong job market could be inflationary, and similarly a weaker data will mean crash of yields. In July we have seen US data trend on softer side – leading to sharp fall in yields. Indian yields too tracked the same. However, India data too is uncertain, with El Nino/monsoon, Crude prices .

G-Sec: Government Securities; SDL: State Development Loans; CPI: Consumer Price Inflation; PF: Pension Funds; EPFO: Employees’ Provident Fund Organization; SLR: Statutory Liquidity Ratio

Let’s revisit our rates call trajectory

Indian Soveregin Bond Yeild 10Y

Source – Bloomberg

To start with,
Recap of events since last release.

US Data has softened, but no conclusive evidence yet

  • Labor market showing mixed signals

    • Continuing jobless claims declining since Mar’23
    • Non farm payrolls declined MoM
    • However, unemployment rate came in lower at 3.6% vs 3.7% (previous month)

Labor market showing mixed signals

  • Services PMI in expansionary phase

    • Stays above 50 (expansion) mark for the 5th consecutive month, although declined sequentially
    • As also indicated in sticky core inflation

US Services PMI

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

Source – Bloomberg NFP: Non Farm Payroll, PMI: Purchasing Managers’ Index

Now our framework
And
What we track

Our Framework

Monetary & Fiscal Policy

Takeaway:
We are neutral overall. We wait for weaker data to change our view

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; B/S: Balance Sheet; FOMC: Federal Open Market Committee; CRR: Cash Reserve Ratio; PMI: Purchasing Managers’ Index; GST: Goods and Services Tax

Stable Domestic Macros
Inflation inched up
Set to rise further (Seasonality & Food)
Though uncertainty ahead!

Inflation inched up, further risks ahead

  • CPI inched up in Jun’23 to 4.81%

    • Higher vs the market expectations as well
    • Led by cereals, pulses and spices
    • Core CPI eased by 9bps to 5.12
    • Weather related disruptions pose a risk
    • Impact of tomato prices to show up in next print

  • RBI’s FY24 CPI Forecast revised down by 10bps to 5.1%

  • CPI to move above 6% based on seasonality


CPI Forecasted

  • Do yields track inflation projection? No.

    • Orange area (chart) is 10Y yields, Black line is CPI

  • Can forecasters predict Indian CPI? No.

    • Green line is forecasters prediction of CPI 1-Year later
    • Blue line is where inflation actually came
    • Guess the error of margin!

  • CPI forecast corelated (not causality) to yields

    • Low predictive power, high current corelation

Inflation Vs Bond Yeild

Takeaway:
Best in CPI probably behind – set to rise up. 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

  • El Nino a real possibility now

    • Sustained negative values of the SOI lower than − 7 often indicate El Nino episodes.
    • India monsoon rain in surplus on overall basis
      • ✓ But with heavy spatial and temporal skews

Southern Oscillation Index

  • El Nino impact on cereal prices was inconclusive as per past data (refer to table below)

    • However, deficient rainfall could impact rice sowing
    • Wheat and rice stocks on the lower side

El Nino impact on cereal prices was inconclusive as per past data

Takeaway:
El Nino a real possibility this time. However, past data does not conclusively show any impact on cereal inflation

Source – FCI, DBIE, Australian Govt BoM

India’s
growth remains resilient
across high and low frequency data.

Will global slowdown test domestic growth?

  • Domestic growth data still robust

    • PMI continues to be in expansionary mode
    • Consistently high services PMI (Jun at 58.5)
      • ✓ Even though it declined sequentially
    • GST collections at ₹ 1.61 tn; YoY growth at 12%

  • Strong credit growth

    • Led by retail, MSME and services
    • Credit to large industry also picking up (specially in infra related sectors)

India PMI Index

  • How closely do yields track growth?

    • Yields have usually tracked GDP growth, with correlation being stronger when growth slows, barring
      • ✓ 2013, rupee depreciation and debt outflows
      • ✓ 2017, during demonetization

  • FY24, growth may not be big driver for yields

    • FY23 GDP came in at 16.1%, in line with RBI projections

FY24, growth may not be big driver for yields

Takeaway:
Domestic growth seems 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

What made RBI Pause?

What drives pauses: Series of hygiene factors

The checklist for pause:

  • When the US Fed starts pausing

    • Reduces risk of capital outflows

  • When inflation is within comfort

    • Reduces risk of inflationary policy
    • Barring 2014, when RBI did not have 6% CPI target
      • ✓ But CPI was falling in 2014

  • When BoP (and currency) is stable

    • Reduces inflationary / external risks

How is the checklist now?

  • ↔ US FED has indicated two more hikes

    • Even though FED has paused the rates for now.
    • US yields much lower, expecting rate cuts in CY23

  • ✓ Inflation moderated to comfort zone

    • CPI <5%, but will increase further

  • BoP (rupee) is stable

    • Bop in surplus in Q3 and Q4FY23

Series of hygiene factors

Takeaway:
RBI delivered a pause in Jun 23 MPC, but higher than expected FOMC rate hikes to remain concern

Source – Bloomberg RBI: Reserve Bank of India; US FED: US Federal Reserve; BoP – Balance of Payment; CPI: Consumer Price Inflation: MPC: Monetary Policy Committee

What makes RBI Hike?

Although unlikely, as the FX reserves have
increased significantly

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

  • RBI FX reserves have increased significantly

    • Forex reserves increased significantly to USD595bn

  • RBI FX Reserve / IMF FX adequacy ratio declined sharply

    • Buffer of ~USD 93 bn to reach 2013 and 2018 levels (~150% ratio)

RBI FX reserves have increased

  • RBI only hiked rates twice in past 10 years, barring now

    • Increased rates to control rupee, not inflation

  • RBI has tolerance for inflation, not rupee fall

    • In 2018, inflation was within RBI’s target levels
    • In 2013, inflation was high for long yet RBI cut

  • When RBI FX reserve fall

    • RBI avoids using reserves and does rate hikes to control rupee.

RBI hiked rates

Takeaway:
FX Reserves have increased significantly

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

RBI actions followed FOMC – expect the same going ahead

  • Fed paused in the June’23 policy

    • RBI has echoed FOMC decisions, albeit more moderately
    • RBI started hiking after Fed
    • RBI rate hikes 25bp lower than Fed – in every policy

Rate action by Fed and RBI

  • FOMC DOT PLOTS expects two more rate hikes.

    • If FED hikes twice, probability of MPC hikes
    • We do not expect RBI hikes to occur, but “probability” will be priced by markets

  • FOMC expects rate cuts in 2024,

    • A 100 bp rate cut expected in 2024
    • But there is a wide dispersion – signifying data dependence

Dots for Fed Funds rate year end

Takeaway:
RBI MPC has shades from FED FOMC. If Fed hikes a lot, don’t be surprised with RBI

Source – Bloomberg, Federal Reserve RBI: Reserve Bank of India; US FED: US Federal Reserve; FOMC: Federal Open Market Committee; MPC: Monetary Policy Committee

Why should RBI follow FOMC?

  • RBI tracks FOMC because of emanating rupee risks…

  • ..But rupee is stable, so why should RBI worry about FOMC?

  • Because no one knows how rupee will react if FED rates go ~6%

    • Higher FED rates could lead to recession in US impacting
      • Software and merchandise exports
    • There could be risk-off and capital outflows from emerging countries

  • Bottom-line: We are wary of risks. We don’t know how, or even if they will pan out.


FOMC: Federal Open Market Committee

Inflation set to rise
Growth is resilient, but risks ahead
MPC unlikely to act in near future
Only tail risk to RBI policy rate is large
FOMC actions

Let’s turn to Fiscal policy
Generally, it drives the long bond yields
It is reflected in demand/supply mismatch

Only small part of bond buyers are
discretionary buyers.

They drive yields.

Supply fluctuations is borne by these
buyers.

Gsec market still driven by lumpy institutions

Gsec + SDL Holdings

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

Comfortable SDL demand-supply metrics

  • State cash balances back above ₹ 2 trillion

  • Center has front-loaded devolution of tax

  • Last time we said: low cash balance resulting in higher issuance

  • Now expected to be in line with the calendar /marginally lower at best


State Cash (T-bill holdings)

  • SDL borrowing has now normalized

    • Apr’23 borrowing 60% lower than calendar
    • May’23 higher than calendar (Rs 3k cr)
    • June’23 borrowing largely in line with calendar

  • SDL issuance impact expected to be limited


SDL Inssuance

Takeaway:
SDL supply may remain muted in FY24

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

Banks have already bought a significantly!

  • Banks SLR holdings has risen sharply

    • Part of SLR holding (~1%) is hedges of FRA & TRS, and not naked holdings
    • Yet, SLR holding remains high

  • SLR ratio may reduce, still absolute demand will absorb supply for FY24

    • Natural NDTL growth will still lead to demand

  • But banks have bought nearly ₹ 2 tn in Q1

    • Rest of the year demand will be muted

Banks SLR holdings

  • Yields track RBI OMO purchases

    • Yields have strong correlation with RBI OMO
    • Demand/Supply mismatch is filled in by RBI

  • RBI OMO pushed to latter half of FY24


Yields track RBI OMO

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 infusion delays OMO or CRR

  • RBI announced withdrawal of ₹ 2000 notes (Demonetization 2.0)

    • 76% of ₹ 2000 notes (2.7 tn) in circulation already returned as of Jun’30
    • Of this, ₹ 2.37 tn in the form of deposits

  • Core liquidity comfortable at more than ₹ 2.5 lac crores


Core liquidity

  • RBI announced dividend of ₹ 87K cr

    • Surpassing budget estimates of ₹ 48K cr

  • Liquidity to remain in surplus for few months

    • Due to seasonality of liquidity
    • Seasonal infusion of ₹ 45-60K cr as we enter a period of reversal in CIC until Q3FY24

  • OMO/CRR possibility pushed to Q4/Q3

    • Liquidity infusion will not be needed

Daily Liquidity Adjustment Facility

Takeaway:
Chances of OMO or CRR pushed back to at least Q3, probably Q4

Source – Bloomberg, Internal OMO – Open Market Operations; CRR: Cash Reserve Ratio; CIC: Currency in Circulation; RBI: Reserve Bank of India

How much is the excess supply

  • Excess supply can be matched by

    • ✓ G-sec supply 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

Supply & Demand

Takeaway:
Estimated excess supply of ₹ 1.06 tn 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 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

While RBI tracks FOMC, but
should Indian yields track
US yields?
No. US yields will create noise,
not trend.

Indian yields – Dancing on its own chords

  • FOMC rate at 5.25% - more hikes at play?

    • Labor data has softened, but no conclusive evidence yet
    • Tails risks of services inflation remaining sticky

  • Are spreads of US Treasury and Indian Govt. Bonds low?

    • No, Bond yields difference mimics the inflation and policy rate differential.
      • ✓ 10Y yields seem to have priced in the inflation spread

  • Even if US yields don’t fall, Indian yields may.


Normalised Central Bank Policy Rate

  • Are Indian yields tracking US Rates/currency /crude? NO

    • Currency is stable
    • Trade deficit reduced significantly
    • India yields more driven by the local factors

Indian yields tracking US Rates/currency /crude

Takeaway:
India bond yields more driven by domestic factors.

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

What else
that
can’t be bunched up

Election related risks on the card

  • Is Election Year bugle sounded by MSP hikes?

  • MSP hikes are substantial

    • Could lead to further inflationary pressures.

  • But can be offset by Pulses and Paddy buffer

    • Govt. has substantially large buffer

Election Year bugle sounded

  • Although MSP hike in this election year has been lower than the previous election years


MSP Increase

Source – Bloomberg, PIB, Internal MSP: Minimum Support Price

Supply-demand to be the key driver for short end yields

  • Divergence between credit and deposit growth continues, but narrowing down now
  • Demand supply seems to be well-matched
  • Expect normal volatility of 10-15bps
  • Sharp spikes may be on account of issuance from some PFIs, whose supply is structurally high
CD Issuances

Credit Vs Deposit Growth

Source – Bloomberg, Internal CD: Certificate of Deposits; CP: Commercial Paper; T-bill: Treasury Bill

Term premia: Data dependent

  • If there is an extended pause (likely scenario)

    • Premia is on a lower side… One may see volatility at these levels.

  • But if there is even one more hike (low probability)

    • Premia should rise significantly – touching March levels

  • If there is short pause, followed by cut (low probability)

    • In 2014/2018, the term premia reduced
    • Both these instances led to rally in duration yields

Term Permia

Takeaway:
Term Premia has been low historically in years of pause

Source – Bloomberg

DSP FI Framework checklist : What is our view on yields movement?

DSP FI Framework checklist

DSP Duration decision: How much of yield movement is priced in?

India Sovereign Forward Curve

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

Market expects yield curve

Source – Bloomberg; as on 6/Jul/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

DSP Portfolio Creation: Multi-step process
  • 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 Credit Investment Process

DSP Asset Allocation: Corporate bonds vs. Sovereign Bonds

  • Higher supply of corporate bonds so far

    • 2mFY24 issuance at 2.5x of 2mFY23 led by AAA & AA rated segment
    • AAA supply increased from ₹ 59k crores in May to ₹ 77k crores in June
    • PSU supply has picked up along with NBFCs

  • Issuances expected to remain steady going ahead


Corporate Bond Issuance

  • The corporate bond spread remains elevated

    • 3Y NBFCs providing steady accrual
    • AAA PSU Spreads remain to be in the narrow band of 50-55bps
    • Demand-supply well-matched & expected to remain the same

AAA PSU Vs Govt Bonds

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

Source – Bloomberg, CCIL, Internal

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)

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