Informist, Thursday, Jun 13, 2024

--ANZ Bk Agarwal: RBI to focus on inflation, take cushion from growth

--CONTEXT:ANZ Bk head of trading Nitin Agarwal's remarks in interview

--ANZ Bk Agarwal: See 50 bps rate cuts FY25, likely starting Oct-Dec

--ANZ Bk Agarwal: May see an October rate cut only if monsoon normal

--ANZ Bk Agarwal:Without growth shock, MPC rate cut cycle won't be big

--ANZ Bk Agarwal: Expect Fed to start cutting rates in Jul-Sep

--ANZ Agarwal:RBI may focus on liquidity mgmt as govt spend kicks in

--ANZ Bk Agarwal: Prefer to be in 10-14 year segment in gilts

--ANZ Agarwal: Spreads to stay flat between 1-yr, 10-yr gilts Sep-end

--ANZ Bk Agarwal:See stability, low volatility in FX mkt on RBI action

--ANZ Bk Agarwal: See FX reserves rising as RBI mops up FPI inflows

--ANZ Bk Agarwal: Still see OIS as a receive on upticks

--ANZ Bk Agarwal: FPIs have mixed reviews of setup process in India

--CONTEXT: India to be included on JP Morgan bond index Jun 28

--ANZ Agarwal:Most big FPIs already present or setting up ops in India

By Pratiksha and Aaryan Khanna

MUMBAI – Short-term bonds, which have been out of favour because of tight liquidity conditions for the last 10 months, are unlikely to gain popularity anytime soon even if likely government expenditure eases the ongoing cash crunch in the banking system, ANZ Bank's Head of Trading Nitin Agarwal said. He believes that investors will demand a premium to bear the risk of tight liquidity conditions making a comeback, especially since they do not foresee big rate cuts ahead.

India's rate cuts in 2024-25 (Apr-Mar) are not likely to be more than 50 basis points, according to Agarwal, whose estimate is more conservative than ANZ Bank Research's view of a 75-bps of rate cuts during the year. He believes that such a shallow rate cut cycle would not be incentive enough to buy short-term bonds whose pricing tends to be particularly sensitive to overnight borrowing rates.

The Mumbai Interbank Offered Rate has tended to drift towards 6.75%, the upper bound of the RBI's policy rate corridor, on most occasions since August. Consequently, yields on short-term bonds are nearly as much as those on longer-dated securities, resulting in a flat yield curve which, according to Agarwal, may be here to stay.

"The spread is quite flat, and I expect it to remain flat (between 1-year and 10-year paper) since we are not expecting a deep rate cut cycle. Additionally, there is a bit of risk premium that market has assigned in for banking liquidity since there will be a fair bit of uncertainty around that. I don't think RBI is letting overnight rates settle at 6.25% or SDF (standing deposit facility rate) anytime soon."

The 364-day Treasury bill--a proxy for the government's 1-year borrowing cost--was set at 7.01% at the auction this week, the same yield as the 10-year benchmark 7.10%, 2034 bond. Agarwal's view diverges from the consensus, which expects an influx of liquidity in the next few weeks to bring the 364-day T-bill rate down to 6.75% by September-end.

"...the 1-year T-bill may come down to 6.95%, but the risk premium will remain," Agarwal said, when asked where bond spreads would be by September-end. "Which means that if notional investors will still have to focus on 10-year and the longer end segment in pursuit of strong gains."

Because of this, Agarwal prefers his portfolio to generate as much gain as it can through the 10-year to 14-year space in government bonds. Longer-term segments do not offer him the liquidity to trade freely, sacrosanct for a foreign banker. And neither is the spread between the papers attractive enough to trade in those segments. He said he was neutral on other parts of the gilt yield curve.

In the overnight indexed swap segment, Agarwal recommends receiving fixed rates on upticks as a trading strategy, as swaps are not pricing in interest rate cuts in the current financial year. The one-year swap rate is an easy receive around the current 6.80% level, but he doesn't expect to generate much return because of how quickly the MPC would stop cutting rates. "Essentially, it's more of fine-tuning than a rate-cutting cycle," Agarwal said.

The RBI's focus will turn more towards its management of liquidity, Agarwal said. Government spending is likely to pick up after a stagnant six weeks during the General Elections. Foreign portfolio investment in gilts is expected to generate liquidity surpluses in the banking system over the next few months. JP Morgan will include Indian government bonds in its Government Bond Index – Emerging Markets suite from Jun 28 over a 10-month period.

The RBI will mop-up most of the dollar inflows to shore up its foreign exchange reserves, and deploy its liquidity fine-tuning measures in earnest, before taking more drastic actions, Agarwal said. He expects volatility to increase slightly in the currency market after India's global bond index inclusion comes into effect but expects the rupee to broadly remain stable due to the RBI's active intervention.

"In case inflation glide path pans out and goes lower, then I think RBI will be comfortable doing VRRRs (variable rate reverse repo operations) as opposed to taking these FX forward measures (to manage liquidity)," Agarwal said. "Do I expect RBI to come into the two- or three-year space in FX forwards? I don't think that's going to their first line of defence."

Following are edited excerpts from the interview, where Agarwal discusses the status of FPI readiness ahead of the index inclusion, goes into further depth on monetary policy, and explains his trading calls:

Q. What is your view on the interest rate trajectory in India and the stance? And considering other central bank meetings, how will the US rate cuts play out?

A. Governor Das has categorically said that Indian monetary policy will focus on domestic dynamics. The fundamentals are resilient growth and comfortable inflation, albeit not at the target yet. I think the RBI will continue to take cushion from growth to go a little heavy on managing inflation, which means that rates will stay elevated for longer. I would say October or December possibly looks like the first rate cut, with December more likely. Also, I don't really expect a deep rate cutting cycle. So maybe two rate cuts of 25 basis points each in 2024-25 for India. Essentially, it's more of fine-tuning than a rate cutting cycle.

For the US, growth is holding up and inflation is not falling fast enough. As a bank, our view is US rate cuts to begin in Q3 (Jul-Sep) 2024. And rates coming down slowly, as opposed to the torrid pace of rate cuts that was priced earlier.

I think the focus area of RBI would now be on liquidity management, because they will now have government spending kicking in. And then you'll have the index inflows also starting in full earnest. These combined will bring liquidity to the banking system which will need to be managed in accordance with the monetary policy stance.

Q. The RBI governor was insistent US policy will not influence ours, one way or another. What are the risks from that?

A. That’s a decent risk and can’t be dismissed. What has happened is now the RBI has started focusing on headline inflation, which means that food component gains large significance. Food inflation will frankly be influenced much more by domestic factors than the US. The RBI is using the cushion from growth to double down on inflation. RBI wants to stick to its inflation mandate right now. If monsoon pans out normally, an October cut is a possibility, else we may have to wait much longer.

Q. If the monsoon doesn't pan out normally, are you looking at no rate cuts then?

A. Theoretically, you can make that case. The curve also isn't pricing much, right? That's because the food inflation outlook, which is quite important for headline inflation, is too uncertain right now. Further, without a growth shock, you likely won't have a big rate cut cycle coming up.

Q. Does the index inclusion kind of muddle the game for the RBI in terms of liquidity management, since it is not only domestic anymore? What do you think will be the trigger for larger-scale measures like an an OMO sale?

A. I believe the temporary or fine-tuning measures will be deployed in full swing. Dollars will come into the system. RBI will end up absorbing a lot of them, because we've seen in the past that the RBI tends to be more active with absorbing portfolio flows.

If they see that liquidity is persisting for a long time and hampering their monetary policy stance, I think that's when they will look at some of these OMO or other measures, even the FX measure.

Now, on the volatility associated with the index inclusion. In steady state, we will attain 10% allocation. You can expect at least a 2-3% variation in overall allocation; when funds want to be underweight, they may go to 7.5-8.0%. And when they wish to be overweight, they may go to 12.5%. If that's the case, RBI will need to handle this volatility, or rather, the market needs to be prepared to handle it.

I think once the system is stable enough, and provided the macro fundamentals are strong, the market can handle that. Our market has also become deeper. Longer-end market is stable. Even in the shorter end, if we see fiscal consolidation, bond issuance is decreasing and will become more manageable. Add to it overall financialisation which is underway, that means that banks will continue to play a decent role. Deposit growth, while not keeping pace with credit growth, will remain at a healthy pace. All of this means that the banking sector should be large enough to handle that 4-5% volatility.

Q. What's your preferred trade in gilts right now?

A. Right now we prefer to be in the 10 to 14-year segment. By doing a trade-off between market liquidity, as well as the overall view and direction. The spread between the 14-year and 30-year is good, but a 10-basis point spread does not give me much comfort. Hence, I would favour the 10-year to 14-year segment, while being neutral on others.

Q. And where do you see spreads then, in the 1x10 segment and the 10x40 segment by end-September?

A. The spread is quite flat, and I expect it to remain flat (between 1-year and 10-year paper) since we are not expecting a deep rate cut cycle. Additionally, there is a bit of risk premium that market has assigned in for banking liquidity since there will be a fair bit of uncertainty around that. I don't think RBI is letting overnight rates settle at 6.25% or SDF (standing deposit facility rate) anytime soon.

And if the US is also not in a hurry to cut rates, then the global factors are unlikely to push the above rate outlook too much. Accordingly, the 1-year T-bill may come down to 6.95%, but the risk premium will remain. Which means that if notional investors will still have to focus on 10-year and the longer end segment in pursuit of strong gains.

Q. With the index inclusion coming into effect, how do you see the currency market changing structurally? What happens to the forward curve after index inclusion, in terms of the RBI sterilisation and the hedging of the flows?

A. FX market has been remarkably stable and is likely to remain so as RBI effectively wants to continue building its war chest.

I would say a majority of inflows will help the RBI with reserve accumulation. There might be a slight increase in forex volatility from current levels, but in the historical context, I think that volatility will remain subdued.

Can the RBI step into the FX forward market to manage liquidity? Yes, that's a real possibility; but I think that's a subsequent step post the VRRRs.

In case the inflation glide path pans out and goes lower, I think RBI will be comfortable doing VRRRs as opposed to taking these FX forward measures. Do I expect RBI to come into the two- or three-year space in FX forwards? - I don't think that's going to be their first line of defence.

Q. So considering the RBI's active action and the inflows, what is the level you're looking at for the currency?

A. Within the overall context of low volatility, the currency to a large extent will depend on how dollar plays out. I believe in terms of India-specific factors; we will keep seeing a push to buy dollars. Now, if dollar is strengthening, then possibly we might see lower inflows also. In that case, people might go to the 7.5-8.0% allocation initially, as opposed to going to that 10-12%. Whereas if dollar is weakening, then it tends to be good for emerging markets. If that's the case, then RBI will come in. So, we have an automatic stabilising factor.

Q. The governor said the other day that they have changed their strategy when it comes to NDF intervention. What exactly is the change you're looking at? Have we seen anything lately?

A. We won't know for sure as we are not active in the NDF market from here. But I would imagine that they are possibly intervening more aggressively in NDFs in lieu of their earlier activity in the exchange-traded currency derivatives market.

RBI possibly wants to follow a mix of strategies that employs reserves and one which employs margins, viz the NDF. Nowadays, widespread expectation is that the RBI is intervening. To the extent it is widespread, the market assumes as such and behaves in similar fashion.

In terms of stability of rupee, volatility is low, but some of the actual customers might be happy with the current arrangement. There is more predictability for them.

A section of the market fears a sense of complacency coming in. But for a different segment, people who need to hedge, it might be a good thing in the sense there is more predictability and less urgency to hedge.

Q. What if the currency goes for a toss?

A. This is a real risk; essentially the flip side of the current low volatility and has been flagged as well, that you are bringing a sense of complacency in the market. The current environment is building in expectation of currency stability and that may breed complacence. This complacence may lead to lower hedge ratios and isn't healthy from a long-term perspective.

Q. Considering the volume of bond-swap and forward rate agreement trade we see in the market, is the swap curve not representative of the rate view at all anymore?

A. While decoding a rate view, you must take a combination of OIS and bond curve because bond curve also reflects the fiscal health. OIS focuses a lot on banking system liquidity and on rate expectation. Both liquidity and rate expectation not only incorporate domestic views, but global as well. So, it becomes more art than science. OIS curve also has the advantage of being more freely traded right now, considering the FCY (foreign currency) OIS trades. However, to some extent, these curves incorporate a policy rate plus banking liquidity view, which are difficult to segregate.

Q. If you look at the one-year OIS rate, if you have any expectation that there's going to be a liquidity infusion or a rate cut sometime later this calendar year, that must be a very easy receive for you?

A. Yes, you can say that. However, we expect a shallow 50-basis-point rate cut cycle that also starting October at the earliest. This is my view. ANZ research expects 75 bps in easing. Anyway, with possibilities of fixing staying, say at 6.60-6.65% for now, then you have maybe not more than 10-15 basis point of gain.

Q. Then swaps are not interesting to you at this point?

A. Swaps are currently more a trading view as opposed to a strategic view. Global environment looked softer before the recent non-farm payroll. Let us see how post non-farm payroll US data pans out. Currently, I would look at OIS as receive on upticks.

Q. Considering the incremental inflows from bond inclusion are not so much, do you think that it is going to be a sea change that for the last six months everybody is thinking of?

A. While the quantum of additional inflows expected monthly pales out in terms of our monthly supply, it is still additional demand. And we are assuming that the supply remains as is. Then you have a good demand-supply match. When this demand pans out as per expectations, we should become a little more comfortable.

Q. There's going to be an information gap between a foreign bank like yourself and a wholly domestic player like a PSU bank post the index-inclusion. What kind of trading advantage do you see?

A. First, I'm not sure that there is an advantage because one, CCIL has ensured that all trade information is actually available real time. Maybe you will see more hits coming on the CCIL reported deal segment as opposed to what there used to be. That should even out any information asymmetry.

Second, when you're looking to source these bonds, even though they are FAR (fully accessible route) securities, they will be sourced from the secondary market and will impact the price. Price will still embed all available information.

Q. In terms of business, what wins have you already had leading up to the index inclusion and what are you constructive on going ahead? In terms of enhanced FPI client base, because I imagine at least from what we've heard, a lot more FPI's have to be looking at India post index inclusion.

A. Once the FPIs get confidence in Indian government bonds, hopefully they will start exploring other segments also. That's not an immediate path that we're talking about but over time hopefully they also start looking at adding state development loan portfolio and corporate bonds, which is where the real win for the country and economy will come in.

Q. So, any timeframe for that?

A. I think it is a more of a medium to longer term timeframe because first, they need to come here up to the 10% allocation. We need to see that the currency remains stable and macro factors remain attractive. These investors are long-term passive investors. They don't really take a call on six months of their performance. They might possibly see for two years and then evaluate future course of action. And then some banks will approach them that you are already active in India. It's not an immediate or a short-term win or a business opportunity. But yes, it is an opportunity for the longer term, which is how the policymakers must look at it.

Q. In terms of process, do you expect on Jun 28, there will still be hurdles for smaller FPIs?

A. The process is what it is and hasn't changed. We've heard mixed reviews from the FPIs about the process of setting up.

I think most FPIs, who are looking at any reasonable allocation are either already setup or are in the final stages of setup. The weightage in the index will also gradually increase by 1% every month, so funds have time. The smaller FPIs would have their set up in the pipeline and will get it done in time; banks also will possibly focus on the smaller FPIs, once the bigger FPIs are set up. End

US$1 = 83.55 rupees

Edited by Akul Nishant Akhoury

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