In Rs. Lakh Crore Spread (%) A Dislocated Bond Market What does it mean for investors? Since the release of the RBI monetary policy committee minutes on 19 th April 2018, bond yields have spiked. The benchmark 10-year government security has seen the yield rise by about 70 basis points, while the impact on the short end has been even more. Everything from 3-month commercial paper to 3-year AAA bond yields have risen by 100 basis points or more. Talking to market participants, one gets a sense of bidless-ness, the lack of buyers in the market. Thus with few trades, the price has moved down a lot (yields have risen). It seems the market is grappling with a lack of liquidity a rather strange situation when the RBI is actively mopping up excess liquidity through reverse repo operations. Normally short rates (money market and short term bonds) are determined by the policy rate/stance and liquidity. When liquidity is tight, the market demands a premium to hold bonds over cash. Conversely when liquidity is easy, there is very little premium to be had. A quick look at the short term premium shows that the spread between short bonds and the overnight rate is the highest since 2013/14. Currently we are in a period of what looks like easy liquidity but high spreads. Five years ago, we were in the midst of the taper tantrum and India was part of the fragile five having seen a large currency depreciation on the back of persistent high inflation, current account deficits and budget deficit. Most macro indicators now suggest we are way off from what can be called a crisis, but why then are spreads so high? 10.0 8.0 6.0 4.0 2.0 0.0-2.0 Bond Yields Have Seen A Signifcant Surge Despite Neutral Liquidity 3.0 2.5 2.0 1.5 1.0 0.5-4.0 0.0 Nov-16 Feb-17 May-17 Aug-17 Nov-17 Feb-18 May-18 Liquidity (LHS) 3 Year AAA over Repo (RHS) Source: RBI, Bloomberg, Axis MF Research Liquidity for the purpose of this chart refers to Repo functions, Standing Liquidity Facilities (SLF) and Market Stabilization Scheme (MSS)
RBI s conflicting positions are leading to difficulties for market participants to judge the stance of monetary policy The minutes of the MPC for April revealed that most members were worried about upside risks to inflation. The deputy governor in charge of monetary policy warned that he was planning to vote in favour of withdrawal of accommodation in the next policy meeting in June (that is central banking code for signalling a rate hike). However, the policy statement that was released on the first week of April made no mention of this hawkish stance (the same deputy governor also addressed the press on that date). In fact, the market perceived the policy to be distinctly dovish in relation to the February policy. Rates across the curve came down, and so did expectations of rate hikes priced into swaps. The gap between the statement and minutes reflects a broad difficulty that RBI has had in this new era of the MPC. Repo V/s Reverse Repo rate 6.5 6.2 5.9 5.6 5.3 5.0 May-16 Aug-16 Nov-16 Feb-17 May-17 Aug-17 Nov-17 Feb-18 May-18 Repo Rate Reverse Repo Rate Source: Bloomberg, Axis MF Research Since the first meet of the MPC in October 2016, we have seen rate cuts (October 2016 and August 2017), rate hike (April 2017), and surprise pauses (December 2016 on the back of demonetisation). This has led to significant volatility around and following policy dates. In addition, the RBI s warning to banks on mark-to-market losses in January 2018 led to a series of auction fails which continues to the present. The banking system is sitting on about Rs. 10 lakh crores of excess SLR bonds with an average duration close to 4 years. With over 100bps sell-off in the last year, this means that the system is sitting on mark-to-market losses of Rs. 40,000 crores or thereabouts. We must remember that banks added about Rs. 3 lakh cr. in G-Secs following the huge inflows in deposits after demonetisation. Is it any wonder that banks are not displaying any appetite for more long duration bonds in this environment? Liquidity is plentiful, but poorly distributed When it comes to monsoons, we are used to hearing terms such as temporal and special distribution. The same can now be applied to banking liquidity. PSU banks in general have excess liquidity, while private banks are in deficit. Partly this is because nationalized banks have been hesitant in making new loans thanks to precarious capital positions and RBI restrictions (PCA norms).
In Rs. Lakh Crore Loan Growth YoY(%) As of Dec 2017 Quarterly Results Private Banks 22% Non PCA - PSU Banks 8% Average 8% Total PSU banks 4% PCA - PSU Banks -5% -5% 0% 5% 10% 15% 20% 25% Source: Bloomberg, Capitaline, CLSA, Axis MF Research PCA Banks tagged under the Prompt Corrective Action framework of the RBI Thus the nationalized banks have been lending to RBI in the reverse repo window while the rest of the system has been struggling for liquidity. The banks with excess liquidity are also not lending out excess liquidity to other banks or NBFCs thanks to intra-financial-system limits. Temporarily too liquidity distribution has been poor. Despite the surge in liquidity after demonetisation, we had a period starting December 2017 when the system went into deficit liquidity thanks to a large build-up of government cash balance (in part aided by market stabilisation scheme treasury bills). Since April this year we have been in surplus mode again. But the faster than expected remonetisation has meant that currency has been leaving the system quickly and the system is expected to be in deficit mode soon. The RBI s suspected intervention in forex markets to reduce volatility has also added to the outflow of Rupee liquidity. 10.0 System Liquidty 8.0 6.0 4.0 2.0 0.0 Nov-16 Feb-17 May-17 Aug-17 Nov-17 Feb-18 May-18-2.0-4.0 Source: RBI, Bloomberg, Axis MF Research
On the whole for those that matter (i.e. for those who are actually lending), liquidity is tight and is expected to remain tight barring some regulatory action. Oil, Rupee, Fed the global cycle is having its own impact While we have been grappling with our own local issues the world is getting around to accepting higher rates. US 10-year treasury rates have crossed the 3% mark for the first time since 2013. Most emerging markets have seen their currency and bond markets roiled by outflows. The dollar is strong and oil has reached the $80 per barrel mark. So the global environment is not very bond friendly. Having said that, this affects the longer end of the curve and should not have any impact on money or short rates. The RBI has sought to pre-empt some pressure by relaxing some norms (while introducing new restrictions) on foreign portfolio investors. FPIs are now permitted to buy government securities without any maturity restrictions (including treasury bills, previously there was a minimum residual maturity requirement of 3 years). The minimum maturity requirement for corporate bonds has been reduced to 1 year. Despite these relaxations, there has been a net outflow from FPIs over the past month. 5,000 3,500 2,000 500-1,000-2,500-4,000 Source: NSDL, Bloomberg, Axis MF Research. As on 25 th May 2018 The state of the fisc India FPI Flows - Debt Market (In US$ Mn) The rising price of oil has once again raised fears of fiscal slippage if oil related excise duties are reduced. The RBI estimates that the fall in price of oil after 2014 has resulted in a saving of close to 0.5% of GDP in deficit in FY2018. Put another way, if oil were back at $100, the deficit for FY18 would have been 4% of GDP instead of 3.5%. The 3.5% number is also arrived at without considering the PSU recapitalisation of approximately Rs. 80,000 crores last year. If we add this back, the deficit would have been higher by another 0.5% of GDP. By the way if we argue that investments in PSUs should be brought below-the-line, so too should divestments. In that case, the deficit would be higher by Rs. 1,00,000 cr. Remember also that the total bank recap plan is about Rs. 2.1 lakh cr. We still have a way to go.
Fiscal Deficit and Impact of Crude Oil Price Movements on fiscal Deficit (as per cent of GDP) Year Impact of Crude Oil Actual Fiscal Deficit Price Movement (As a % of GDP) (% of GDP) 2015-16 3.9 0.32 2016-17 3.5 0.62 2017-18 RE 3.5 0.48 Source: RBI Bulletin April 2018 RE Revised Estimates Terms of Trade Refers to the impact of Crude oil price movement Should there be some fiscal slippage this year, we are likely to see the impact in the second half. This year that is an additional complication for the market as about half of the borrowing programme is already scheduled for the second half. Normally 65% of the borrowing is completed in the first half. This is to ensure that the government stays out of the way when corporate credit demand picks up in the busy season. Now we are potentially looking at a risk of government borrowing crowding out corporate credit even as liquidity is getting tighter. The outlook for government bonds is murky are we prefer to maintain a relatively low duration stance as a result. The RBI can mitigate some of this risk through open market purchases of government securities. There might yet be an opportunity to get into this market, but we think it is a little too early. What does this mean for investing in bonds? Given the difficulty in judging the RBI s stance on monetary policy, the global rate outlook and the state of the fiscal, we prefer to stay out of the long end of the curve. The situation at the short end is another matter. Normally we see 100-150 bps between the repo rate and 1-year bonds in a rate hike environment/tight liquidity environment. Now assuming RBI delivers 100 bps of rate hikes over the next 12 months, we anticipate that the 1-2-year rate will move to ~8.5% (repo rate will be 7%). What explains short-term rates at near 8.5% today with the overnight at 6%? We believe the market is dislocated and is currently offering very good value at the short end. AAA rated bonds are back to where they were in 2015 when the rate cut cycle was just starting. While the RBI may hike this year, there is nothing in their projections that indicates runaway inflation of the sort that would trigger 100+ bps of rate hikes. Hence we believe short term debt strategies especially high quality bonds look attractive at this stage.
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