Informist, Monday, Dec 4, 2023
By Aaryan Khanna and Nishat Anjum
NEW DELHI/MUMBAI - Nomura has a positive bias on India's interest rate markets, but it is "certainly not" a top pick for it, with bonds in Indonesia and South Korea providing a better opportunity in the region, according to the brokerage's Emerging Markets – Asia Rates Strategist Nathan Sribalasundaram.
"We don't see a clear rationale to get long on IGBs (Indian government bonds) to play for an RBI (Reserve Bank of India) rate-cutting cycle in the next few months or a quarter," Sribalasundaram told Informist in an interview on Friday.
He recommended India's seven-year government bond to clients just last week, but the expected returns pale in comparison to returns on government bonds in other economies that seem closer to a rate cut cycle.
"I think domestic factors, like the growth and inflation dynamics of India are not giving a huge amount of catalyst to India bonds," he said.
India's gilts have underperformed more than expected over the last month, which the strategist considers an opportunity to stock up on bonds. Since overnight indexed swap rates have already reacted to the sharp fall in US Treasury yields since October, he expects the 10-year bond's spread over the five-year OIS rate to narrow slightly heading into 2024.
On Friday, the five-year swap rate ended at 6.54%, while the benchmark 10-year bond closed at 7.29%. This makes a spread of 75 basis points between the instruments, which Sribalasundaram termed "neutral-ish" and "not very exciting".
Regardless, the undeniable tailwind to India's rates market is the inclusion of the country's government bonds on global bond indices, which should begin driving inflows into India's government bonds in Jan-Mar, he said.
India will be included in JPMorgan's Global Bond Index – Emerging Markets suite on Jun 28, with a 1% weight increase over a 10-month period. Sribalasundaram expects the bulk of the anticipated $23 bln of inflows into India's gilts from the index inclusion to arrive over the course of 2024.
By the middle of Jul-Sep, the yield on the benchmark 10-year bond should fall to the range of 6.50-6.75%, as inflows from foreign investors hit the market in an environment in which the RBI is cutting rates, the strategist said.
Nomura is one of the few securities firms that expect a rate cut in India before the US; most other analysts predict that the Monetary Policy Committee's rate actions will follow the US Federal Reserve's cuts.
"We still do expect RBI to cut before the US Federal Reserve and still expect the quantum to be meaningful in terms of 100-basis-point rate cuts by the RBI in 2024-25 (Apr-Mar)," Sribalasundaram said. Nomura's economists expect rate cuts in India to start in August, against September for the US.
As for expectations from the RBI's policy review this week, Sribalasundaram awaits more clarity from the central bank on its plan for conducting open market bond sales through auctions, something the RBI has said it would consider to curb liquidity.
Following are edited excerpts from the interview on Sribalasundaram's views on a breadth of issues relating to Indian financial markets:
Q. When do you expect rate cuts in India? Now that bets on the March/May cuts in the US are firming up, does that change the timeline of rate cuts here?
A. On a top-level view, our US economists have pushed down the first Fed rate cut till September 2024, so that's a pushback by a few months. But I do think the path in 2024 may not be as clear as the market is suggesting. The market is certainly bullish on the timing and quantum of rate cuts in the US.
For India, the resilience in the economy that we have seen, especially in something like GDP growth (released) yesterday (Thursday) and the resilience of the global economy does mean that our economists have already pushed back the India rate cut to August 2024. So, we still do expect the RBI to cut before the US Federal Reserve, and still expect the quantum to be meaningful in terms of 100 basis points rate cuts by the RBI in 2024-25 (Apr-Mar).
Q. The RBI has brought out surprises in each of the last two policies. Anything offbeat on your radar to look out for at the upcoming policy?
A. I was certainly surprised. As you mentioned, the two surprises were the ICRR (incremental cash reserve ratio) and the threat of OMO (open market operation) sales.
I think that the message is probably quite clear from the RBI — that they want to maintain the hawkish bias. I mean, we've certainly had inflation risks surprise us on various occasions in India. And certainly, I don't think we're quite out of the woods yet in terms of CPI, maybe hitting closer to the top end of the band again; there were several such months in 2023.
So, the inflation risks are still there. I think in terms of expecting another surprise, it's always hard to pick and choose what could be announced.
Certainly, we should expect more continuation or more clarity on OMO sales announcement, as this was announced at the last policy meeting, and nothing has been undertaken since the meeting.
Now, my personal view has been that from a liquidity perspective, liquidity was never expected to get into a meaningful surplus, which would require the RBI to conduct OMO sales. And I still don't see that happening, even into the next couple of months. So, the need for OMO sales is not necessarily present in our view from a liquidity perspective.
But I think one thing that has clearly cropped up on the radar for the RBI and some market participants is probably the skewness in liquidity. We know that the RBI has held meetings with several large banks in India to discuss this. If you look at the data, we do see there's often a large amount of liquidity placed on the floor at the SDF (standing deposit facility) and obviously, the borrowing amount on the MSF (marginal standing facility) is still quite high.
This year, the weighted average call rate has been around the 6.80% level for some time now, and MIBOR is 6.90%. So, we're clearly above the top end of the band, for which the RBI may need to offer some guidance, or offer some perspective on why they think this is, and if there are any measures to possibly counter that.
Q. You've given a blow-by-blow breakdown of the liquidity situation until December. What is your view on liquidity beyond this quarter?
A. As a broad view for Jan-Mar, I will break it down into various components. And yes, we don't necessarily have the data on the state bond calendar, but we have the G-sec calendar, and I think we can make a fair assumption of where we think the T-bill calendar would come as well.
So, there's still going to be a liquidity drain from the borrowing side, from the central government. I think a lot will depend on how quickly the government is able to pick up its spending into the end of the financial year.
Seasonally, we normally see a bit of a pickup, especially in February and March, which is a bit of liquidity addition on that front. I think the big unknown comes from the dollar side and the RBI's FX assets policy.
But the house view is that we are probably a little bit in the 'soft-on-the-dollar' camp into Jan-Mar, so from the dollar selling perspective, it is probably less.
And then, another tailwind is also the JP Morgan index inclusion, which is scheduled for the end of June next year. We have seen a bit of FPI buying in IGB (Indian government bonds) over the past month per se. But our view is that these flows do pick up, especially in what we do next year. The RBI is likely to use that opportunity to build back some reserves and inject rupee liquidity in that period as well.
So, I think we are going to get a little bit tighter on liquidity in Jan-Mar just because of the natural drivers, but the offset is coming from the asset side and RBI building back reserves.
However, it's not as if we see liquidity getting back into a meaningful surplus over the next couple of quarters.
Q. The liquidity deficit in the banking system has driven up yields on all market instruments. With inflows expected to start from January, is there potential for money market instruments to ease out?
A. Yeah, I think it will probably be in a bit of a range, especially on things like the one-year T-bill or even some CDs. I think we are in a fairly tight range for the next few months.
I think it's by design. This tightening of money market rates is by design of the RBI. They suddenly wanted to push up the interbank rate from the 6.50% repo rate to the upper end of the corridor through the liquidity channel. They're being very clear that they are using the liquidity channel to counter the higher inflation and prospects of higher inflation.
So, like I say, we're not out of the woods yet, and food inflation seems to just surprise us in India.
As of now, it's probably too early to expect the RBI to let its guard down and guide the money market rates lower.
Q. You recommended a reverse bond swap trade in five-year instruments. Now that it has paid off handsomely, what is next for spreads?
A. These current levels of spreads are probably a little bit neutral-ish. I think, around this mid-set of 70 to 80 basis points on five-year swap spreads is probably the middle of the range, and does nothing too exciting.
I guess a lot primarily depends on the US side, on global rates. The OIS curve has exhibited a much higher beta or correlation to the US rates in the IGB curve. With the growth and inflation dynamics that India currently possesses, the catalysts or the cues are being taken a lot more from the global side than the local economy.
So this bet, I would say, is a lot dependent on the US side. Heading into next year, there's something that we have been thinking about, a bit of a compression back again, with a bit of an outperformance of IGBs.
A lot of that is predicated on the index inclusion and the FPI flow. So, if we do start to see the FPI flow pick up, especially in Jan-Jun, we do expect the IGB to have a positive tailwind from this and be relatively supported.
One other thing – over the past six weeks since the last policy, the IGB curve has also been kind of sitting on tenterhooks; I would say this threat of OMO sales seems to have lingered over the bond market for the past six weeks.
There was a lot of speculation that as soon as liquidity was nearing a surplus, the RBI would announce something. It hasn't happened yet, but it certainly lingered over the bond market and probably contributed to the recent underperformance of the IGB curve, or maybe lack of participation in the IGB curve over the past month or so, when swaps have been rallying quite significantly.
Q. In the OIS curve, the one-year contract still does not factor in a rate cut for the next 12 months. When do you see that happening? Would it be when the overnight MIBOR finally eases, once we see the FPI flows coming in?
A. I think there's a little bit of liquidity easing priced in the one-year part of the curve, but we're not expecting much in terms of rate cuts just yet.
I think a lot of it depends on the incoming data. I think it's hard to kind of choreograph and say how the RBI is going to unwind this liquidity tightness that they've engineered. Certainly, it doesn't feel like the steps will be super-crystal clear. It feels like we'll have to make that decision as and when the data come in.
So, I think if we continue to see more inflation relatively range-bound in this 4-4.5?nd, we see headline inflation come off again from this high 5?ck down to 5%, then we can take comfort on the inflation side.
But I think the real trigger will be when we start to see some impact on the growth side in India – whether that's coming from the external factors of the global growth slowdown, or when we start to see a bit of domestic issues start to have an impact as well.
Q. You've avoided recommending India's bonds. What are the challenges you see right now on the domestic front impeding their performance?
A. Last Friday (Nov 24), we put on our long recommendation on the seven-year IGB. I think domestic factors such as growth and inflation dynamics of India are not giving a huge amount of catalyst to India's bonds.
We don't see a clear rationale to get long IGBs to play for an RBI rate-cutting cycle in the next few months or a quarter.
I think the local dynamics that matter the most are the OMO risk from the RBI, and then the index inclusion flows – they're more global, but certainly a factor that influence IGBs.
As we head into 2024, we are close to the General Elections in May 2024. So, there is some kind of thought on the impact on market players from this.
Then finally, we have had various regulation changes. It may impact upon curves. Just a few months ago, we had the removal of the HTM limit from the RBI. As recently as a couple of weeks ago, we've had risk-weight asset changes on lending to NBFCs and retail unsecured lending. All of these are local factors that are probably impacting the demand side in the IGB equation.
Q. So what will need to change? Is it the growth-inflation dynamics? Are those the things that will need to change for you to recommend other segments of India bonds?
A. I think if one wanted to shift to a shorter part of the curve, say the five-year or even sub-five-year, I think the catalyst really has to come more from growth, even growth over inflation.
Predominantly, if the growth side of India is showing some signs of a slowdown...I guess this year, this narrative of 'India resilience' is taking a bit of a hit.
As I said, I think core inflation is giving comfort to the RBI. And we have seen the RBI cut rates when inflation is still above this 4% target. So, it's not as if it's a very hard core inflation target.
So, we really need to see the growth slowdown. And I guess markets are seeing that — the data that's coming out for India continues to show strength on the GDP side for now.
Q. How attractive do India's bonds look against emerging markets - Asia peers?
A. In comparison to EM Asia, we see it as okay. It's certainly not one of our top picks. Our top picks, we tend to prefer places like Indonesian government bonds, which seem to have a bit more of a risk premia that can be unwound.
Maybe, cuts by some central banks would be a little bit easier or forthcoming. So, BI (Bank Indonesia) may be cutting before RBI.
Then places like Korea, which has probably taken rates to a higher level, against places like India. It has fewer fiscal risks than somewhere like India. And again, a bit of a tailwind from a possible index inclusion for Korea.
It (India) doesn't stand as one of our top picks in terms of duration exposure in EM Asia. But that being said, we do have a positive bias on India. And, as and when we do get a little bit more courage on the growth side, probably as a market we could look to increase exposure.
Q. Is India's underperformance against US yields an opportunity to buy, or is it a warning sign to stay away from the India rates market?
A. Clearly, we're taking the side that it's probably an opportunity to buy, where we've got a bit long on IGB, though it's not a particularly top pick for us. So, even our target for the seven-year expects the 7.30% yield to go to 7.10%. It's not as if we're expecting a 50-basis-point or a 100-basis-point move - the same quantum as the US.
Looking at the US-India spread, we saw pressure on US rates in Q3 (Jul-Sep) and early part of Q4 (Oct-Dec). India bonds were outperforming, and the spread had meaningfully compressed in that period. So, expecting a widening of the spread when US yields come down is logical and explainable.
There's also a bit of policy divergence. By all accounts, we do think that US policy is in a relatively restrictive place at 5.5% (the Fed funds rate). Then there is India policy...at the current juncture, we certainly didn't hike as much as the US did, so we can probably debate how restrictive or not India's policy is at this juncture. Certainly, once we do expect the rate cutting cycle to begin in both of these markets, we would expect the quantum to be a lot less from the RBI than, say, the FOMC. I guess a bit of underperformance is warranted compared to the US.
Though in our view, the underperformance has underperformed too much in the past one month. If we look at IGBs, they are relatively flat compared to the moving treasuries. A lot plays into that, the RBI's hawkishness and the threat of OMO sales, and then the lingering market fears we spoke about. So, that underperformance or that premium that had been built into the IGB can come out especially as we head into year-end, and we don't see any OMO sales pretty close.
Q. We had a question just for perspective, though it isn't your area of expertise. How do India bonds compare to those in Latin America in the EM space, which have reacted much better to the recent fall in US yields?
A. I can't specifically talk on the Latin American economy. That's outside the coverage area for me. Though in a broad picture, the feedback we have is that Asia is not necessarily a top pick in the EM pecking order. There are similar dynamics as I explained to the US and India - a lot of the LatAm central banks were much quicker or earlier in the hiking cycle, inflation rates were going up after the COVID pandemic, and suddenly, some of those central banks have already started cutting rates as well. Whereas most Asian central banks are still kind of in this long, hawkish pause period for now. And again, the level of restriction was also different - Asia had a very mild hiking cycle in comparison to the LatAm region. The scope for the yield rally is less in Asia.
That being said, something that we have talked about a little bit is probably, while the scope of rate cuts may be less in Asia, this stability, or the low volatility environment that Asia does tend to offer is probably an attractive feature or characteristic of the market. As we see in India, bond yields seem to have relatively low volatility trading. It seems like the INR, it's in a very narrow range. Asia does have its place in a global EM portfolio and India is included in that. And while it may not be a top performer in terms of absolute return, it's resilient and the low volatility offers a good characteristic for a certain type of EM investor looking for more steady investment than the volatility that comes with some of the LatAm curves.
Q. In this backdrop, even if we see some passive flows because of the inclusion in the JPMorgan index, do you think active funds will give us a miss?
A. No, I don't think so. We need to separate the active element compared to just the bulk element. What I mean by that is, we are entering the index. That's going to mean we're going to have a 10% weight on the index. So, it's not like an active portfolio manager is going to run 10% underweight on India bonds. There's certainly got to be at least some allocation - like an underweight, maybe 2,3,4 percent, but it means that at least we need to get to that 6-7% allocation first before we start thinking about underweight or overweight of the India bond in comparison.
The way I'm thinking about it is like - let's not miss the forest for the trees. We first need to just get the allocation to India coming into the economy as it in a staggered approach, and then the deviation from the index weight is the secondary factor. So currently, we do expect a large bulk of FPI flow coming in next year from the JP Morgan inclusion.
Q. Once the FPI flows start, do you see the 10-year IGB yield falling below 7% even as the RBI is likely to keep the liquidity quite tight?
A. Into Jan-Mar, it's probably a bit more of a range-bound move. Our target is like 7.1% for mid-January. The seven-year and the 10-year tenures are yielding roughly the same. I get into Apr-Jun and Jul-Sep though, FPIs and the environment where the RBI is cutting rates then certainly, we can easily get down to below 7%. So, I think for the middle of Jul-Sep next year, we're looking for a move to 6.50-6.75% on India 10-year.
Q. Has your expectation of the quantum of inflows due to the JP Morgan index inclusion changed? There's a lot of speculation about the Bloomberg global aggregate inclusion in the Indian bond market. When do you expect further developments on that front, and do you expect inclusion on Bloomberg as well?
A. We are more positive on FPI flows just given the JPMorgan inclusion. I think that is a fairly strong and positive tailwind. As I said, we expect some front-loading in Jan-Mar, and over the course of 2024, we should expect the bulk of that $23 bln to come into the Indian markets.
Now, in terms of the Bloomberg index, there's clearly been a lot of speculation. Normally, just looking historically, the results of the review will come out sometime in Jan-Mar. There certainly has been some speculation around an earlier announcement if India is to be included...we've seen plenty of press reports on that.
I don't think we have a particular edge on whether that's going to happen or not. But the likelihood of Bloomberg, the way I think about it is - look, the positive tailwind is probably already there from JP Morgan flows. If Bloomberg comes, that just adds to the tailwind. Now, clearly, the path to Bloomberg is slow, it is also quite sizable. It's probably in the $15 bln-$20 bln range, we should expect.
But there are a few caveats on both sides of that. This is a global aggregate index, not an emerging market bond index like the JP Morgan one. So, the weighting would be a lot, lot smaller in the global aggregate index, rather than the 10% in JP Morgan. The willingness of the fund managers to have a higher deviation or limited exposure to India is much greater...it's probably a bit harder to predict the amount of flows and the timing of the flow. While we may not be certain, as I said, the tailwind is already there from JP Morgan and if Bloomberg comes as well, and it just further adds to FPI flow and that should come into India next year.
Q. Debt fund heads in India can't stop recommending long-term bonds. Do you expect that to pay off in the next 12 months, or is that trade too crowded? And, in the meantime, is there an opportunity to make money against that trade?
A. There are a few factors here, I guess. First, I'd say a bigger picture – we've definitely seen an improvement, or a structural change in the demand for long-end IGBs over the past two to three years in India. A lot of that has come from the volume growth that we're seeing from the various products that have come on the opposite side, spurring demand for these long-term IGBs. And I'm not sure that tailwind particularly goes away. This is probably a more structural change in the Indian market, which has seen demand for long-term bonds persist for some time.
And certainly the government and the RBI have already reacted to this by the introduction of the 50-year IGB as recently as last month. So, that is a structural change for me that probably ultimately warrants a flatter yield curve in 10s-30s (spreads of 30-year over 10-year bonds) , 10s-40s (spreads of 40-year over 10-year bonds) than what we would have had five years ago.
That being said, the investor choice at the long end is probably causing a little bit more strain. The other kind of asset class to compete with this is probably states' bonds. What we're certainly seen is a pick-up in the issuance in the state bond space, certainly over the past few weeks and in the past couple of months. The way we are tracking it, if we look at the auction amount compared to the calendar amount, the fiscal year's Q3 (Oct-Dec) average is running at 120%. And that compares to Q1 (Apr-Jun) and Q2 (Jul-Sep) at around 80%. Certainly, the supply side of state bonds which impacts the bond decision-making process is a bit of a headwind that I guess fund managers need to be a little bit cautious about. In the near term, I'm a little bit cautious on the long end, but more medium-term. If we are heading for a lower rates environment, then on a total return basis, the long end of the data probably does offer a decent attractiveness in terms of investable opportunity.
Q. So, where would you take a steepener on the curve right now? If you had to make a choice, where would you bet on the widening between short-term and long-term yields on the curve?
A. I don't have a particularly strong view on that. Throughout 2023, we've tried to create a play. Whether that's 5s-10s (spreads of 10-year over 5-year bonds) or even something different, the trick hasn't particularly worked. And I guess it goes back to that structural trend change that we've seen in terms of demand so far. I don't have a high conviction view that the India curve is going to meaningfully steepen over the next few weeks or months.
As we get to the precipice of the RBI cutting cycle, we can see the curve steepen just because we'll see an outperformance at the front end, as liquidity increases and yields come down. Then the bull-steepening scenario becomes a lot more clear than now, when we were now expecting a natural steepening without a big movement in terms of the yield curve. End
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