TheNFAPost Podcast

Global markets are now well and truly into a reflation theme as commodities, bond yields, and inflation expectations have continued to surge. Indeed, these haven’t just broken past recent ranges but in some cases (base metals, US traded inflation expectations) are closing in on their highest levels in many years.

The optimism is anchored on a variety of things with the two great pillars being policy stimuli including prospects of additional substantial fiscal stimulus for example in US, and the optimism around return of activity as vaccinations begin (even as it is truly darkest before dawn in US and Europe).

India’s own optimism with respect to a growth rebound runs strong and seems anchored around the following :

  1. A  relief that large firms and consumers have fared better and even emerged stronger as capacities to produce and spend respectively have been preserved. The higher inequality as a result of the virus (the so called “K” shaped recovery) is a human tragedy and needs policy interventions, but may not immediately show in officially recorded growth.
  2. The evidence that India may have broken the link between return of activity and rise in infections.
  3. A host of cyclical factors that seem on the cusp of a rebound including policy initiatives from the government (details in our year end note:

Bond markets, being the domain of pessimists, had understandably started to view this reflation trade with some amount of trepidation. This is especially so as local CPI, owing to extreme supply congestions and its own compositional quirkiness, had been sitting unprettily at above the MPC’s tolerance band for some time.

Also collateralised overnight rates have been significantly below the official reverse repo rate for a while, presumably due to distribution of liquidity with participants not having access to the RBI window, thereby dragging the front end of the money market curve to at or below reverse repo rates.

This was the backdrop when RBI decided to implement its revised liquidity management framework first introduced in February 2020 but subsequently shelved with a view to provide greater flexibility to market participants on account of the Covid crisis.

Our view is quite benign with respect to this new development and our expectation of a very slow normalization doesn’t change at all (details here: However, many participants in the market are now fearing follow on steps for a relatively quick ‘normalization’ in policy rates.

What Is the Bond Curve Pricing?

The definition of normalization for the market can broadly be phrased as a return to the repo rate as the anchor for overnight rate. No one really expects a hike thereafter for at least the rest of this calendar year. Rather most of the argument pertains to how quickly overnight rates move to the 4% repo rate.

Our view, anchored around slow normalization (underlying reasons described in detail in our year end note), is one of a gradual reduction in the repo – reverse repo corridor. This slow return will also be aided by last year’s quirkiness in local CPI smoothening out and averages probably dropping by upwards of 150 bps in the financial year ahead. Many in the market may have a different view and may be expecting a faster return to normalization, acknowledging the fact that we are at emergency levels of accommodation after all.

Irrespective, one has to remember the starting steepness in the yield curve. Thus while the money market curve may deservedly sway somewhat to these changing expectations, the argument is very much less clearer as one moves slightly higher up the curve.

While a gradual bear flattening is our base case as well, the point is a generic one and needs much further nuance. As a purely illustrative example, government bonds of approximately 6 year maturity (first half of 2027 maturity) are currently around 5.65%.

Assuming that they go up further by 35 bps over the course of 1 year, the holding period return (carry set off for mark to market losses) will work out to somewhere between 4.15% – 4.3% for the full year. Now there are 2 aspects here that are very noteworthy: One, if this happens we are saying that a 5 year government bond 1 year from now will be priced at 6% (since maturity of these bonds would have decayed by 1 year by then).

Even assuming a steeper than usual yield curve but not as steep as currently (again our base case), this can allow for overnight rates to be in the proximity of 4.75 – 5% 1 year from now and still make sense (note this is not a view but purely an illustration). Two, even with such an assumption on rise in yields and in the overnight rate, the holding period return one gets is better than what most money market rates are offering for the next 1 year.

We have gone into considerable detail in the above example to illustrate the point that, as in many things, the general discussion unfortunately loses a lot of nuance. In particular, while not pushing back against the idea that emergency levels of accommodation need to move towards normal levels, investors need to pay attention to what is actually already being priced in the yield curves and accordingly pursue their investment strategies. 

As the above example demonstrates, parts of the yield curve may actually be pricing in too much which may in turn present a viable opportunity. Our active duration funds are largely pursuing the 5 – 8 year government bond space, with the most overweight in around the 6 year, on precisely this logic. That said, and as always, one should remember that these are actively managed funds and can change strategy depending upon evolving views of the fund manager.

It is also this steepness on the curve that makes the cost of waiting on cash a very tedious process. As an example, holding cash rather than the 5 year government bond, loses around 16 – 17 paise a month at the current level of overnight rate.

This translates into roughly 4 bps of a move on the 5 year bond per month, as the cost of waiting. That said, market movements also happen as participants adjust positions to account for incoming information in light of their risk limits and tolerance for near term mark to market losses. However, for the more patient investors this needn’t apply.

Finally, and this is a point we have made before and is shown via the above examples, the decision to invest when yield curves are so steep can be made even when one expects yields to rise and, as a result, for mark-to-market losses to accrue.

The decision rather is only one of whether the carry made offsets the expected mark-to-market losses by a sufficiently large margin for the investment to make sense. It is also to be noted that the logic holds only upto a certain maturity on the yield curve. That is, a steep curve doesn’t automatically mean that the longer the maturity the more the safety. Rather it is about finding those points on the curve where the carry versus mark-to-market trade-off looks the most optimal.

Suyash Choudhary
Head – Fixed Income, IDFC AMC

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