Spike in US long term yields will make it tough on cost of capital & debt leverage…
US 10Y Treasury yield is up from 0.35% to 1.60% (0.32% to 1.62%) between March 2020 and March 2021, and it’s not over as yet with pull bias into 1.60-1.85-2.0%. During this phase FED Fund rate got pulled down from 1.0-1.25% to 0-0.25% as follow-on to easing cycle since August 2019 lowering policy rate from 2.25-2.50%. Impact of zero interest policy (ZIRP) regime on the macroeconomic fundamentals is not yet visible – moderate impact on output & employment and upside risks on inflation. What Next on FED actions on policy rates is not very clear: will it be extended pause in ZIRP beyond 2021 or push FED Fund rate below 0% to pursue Negative Interest rate policy (NIRP) regime if GDP growth expansion is not to desired levels or get the focus back into 1.0-1.25% to contain inflation? Most expectation however is on end of easing cycle for pause in 2021 with zero visibility on 2022.
During this phase, India 10Y benchmark yield eased from 6.50% to 5.75% in alignment with sharp reduction in operating policy rate from 5.15% to 3.35% since March 2020, adding momentum to easing cycle of June 2019 lowering Repo rate from 6%. There’s better clarity in the Indian context – expectation of extended pause in policy rate at 3.35-4.0% and retention of overnight rate at lower end of LAF corridor around 3.35%. While there’s no case for Repo rate hike in FY22, when CPI is seen to stay steady at 4-6% (and average of CPI & WPI at 2-4%) till achievement of (beyond FY22) GDP growth stability at 6-8% (helping to contain fiscal deficit below 4.5% of GDP), 10Y yield pull bias will be for shift of comfort range into 6.15-6.50/6.85% in alignment with India-US 10Y yield spread resistance at/below 4.50-4.65%.
What Next on shift into FY22 is straightforward… Excess system liquidity will anchor overnight rate around Reverse Repo rate as RBI continue to pump in liquidity from combination of OMO, spot USD/INR purchases and Buy/Sell swaps. So, worst case spike in short term rates is 65 bps as and when operating policy rate is moved up from 3.35% to 4%. Given that RBI is stuck with ensuring stability on ₹ exchange rate and medium/long term bond yields through rest of 2021 (till near completion of FY22 market borrowing), cost of working capital will be affordable to borrowers. On the other side, demand-supply dynamics will continue to exert upside pressure on 10Y benchmark yield beyond 6.15-6.25%, intermediate zone of unwind from 5.75-5.85% to 6.55-6.65%, while not seeing risk beyond 6.50-6.65%, where buy & hold interest would emerge shifting appetite from equities to Gilts & investment grade corporate debt. So, all combined, interest rate dynamics will remain supportive to growth (for output & employment expansion) and investment (for capacity & value expansion). Will FPIs like Gilts when 10Y yield spread around 4.5% when USD/INR at lower end of 72-77?
USD into value normalisation is good for INR to ensure price stability to accelerate offshore inflows…
USD Index DXY collapse from 103.50-105 to 88.50-90 (103.96 to 89.17) between March 2020 to January 2021 is followed by resilience at 88.50-91.50 (around 90) with pull bias into 93.50-96.50 (around 95). It’s comfort that multi-year big-picture of 88.50/90-103.50/105 stays intact & valid. Most cues continue to favour USD including the safe-haven status, shift from Gold to USD from end of rate easing cycle and turnaround in growth from contraction to accelerating expansion against muted inflationary pressure. So, good to assume short term upward bias at 90-95/96.50, and not ruling out extension into 96.50-103.50 (for stability around 100).
USD/INR in the meantime got pushed back at 72-77 from 77.01 to 72.27 (between April 2020 and February 2021), and would have gone down deep into 68.50-71.50 (around 70) had not RBI added over $100 Billion between March 2020 to February 2021 to its reserves, which is at striking distance of $ 0.6 Trillion. Given the robust capital account flows and RBI’s huge appetite for US Dollar, there’s no problem in establishing ₹ exchange rate stability when the going is good. But could get worse if headwinds from external dynamics get stronger and FPIs get into pause or reverse mode on India appetite.
What Next is mixed on ₹ exchange rate but would be better than interest rate outlook, if FPIs stay neutral on India. Will FPIs find India debt attractive when 10 year yield spread down from over 5% to below 4.5%, and worse when 1Y spread against 10Y is negative – inverted curve! So, as always, the tussle is between FPI and RBI. While it’s not difficult for RBI to absorb excessive $ inflows, it’s tough to handle simultaneous demand from FPI pullout and importer’s panic entry. It gets lumpy when dollar demand far exceeds supply from both importers & FPIs – set up of so-called “lead & lag” play, making USD as scarce commodity. The hedge strategy, therefore is not to stay overexposed either way, good for exporters when 12M at 78.50-80 (spot above 75) and for importers when 12M at 75-76.50 (spot below 72.65), which would help RBI to administer USD/INR exchange rate stability at 72-75. Given that FPIs appetite would be between risk-neutral and overweight, there’s no need to panic not withstanding USD strength against majors, and taking optimism from elevated interest rate and growth optimism.
Will surge in commodity prices in general and Brent Crude in particular be show stopper…
Brent Crude bounce back from $15-25 to $65-75 from start to end of FY21 can’t be ignored when it gets heavy on CAD and inflation. More so, when big-picture focus is sharply up from $25-60 to $50-85 with direct impact on consumers – high probability of petrol & diesel price shooting up beyond ₹100! Will Central & State Governments reduce tax with alignment to GST maximum tax structure to avoid pushing prices beyond 100? Can the system absorb higher fiscal deficit & market borrowing from this tax reduction? Higher Brent Crude price along with the need to allow orderly depreciation on ₹ exchange rate emerge as major irritant while in pursuit of double-digit GDP growth expansion in FY22.
It’s good that Gold has been in back & forth mode between March 2020 & now – up from $1450-1465 to $2065-2080 (between March & August 2020) before down now at $1685-1700. It’s good feel when the volatility got restricted within set big picture. Gold started losing safe-haven appetite from fiscal stimulus driven economic capacity expansion, high probability of end of rate easing cycle, bounce back of USD Index from base 88.50-90 and no major risk on inflation. Gold push back below $1765 is negative shifting short term focus down at $1450/1585-1765. Will lower price increase import of Gold to make it heavy on INR?
What’s impact on India equities from external headwinds and cross winds from domestic dynamics? Will comfort be derived from high probability of double-digit growth expansion?
NIFTY (spring back) re-rating from March 2020 low 7511 to February 2021 (all-time) high 15431 defied everything – some call it dream come true and beyond expectations (when it surpassed start of 2020 high 12430) while many see it as insane when not reflective of real economy. But, the reality is that combination of fiscal stimulus & abundant liquidity at abnormally low rates did push monies into equities, which is fine but will it sustain overtime?
Bank Nifty spike from March 2020 low 16116 to February 2021 high 37708 (through 2020 high 32613) is more surprising when Indian banking sector had to absorb pre-Covid NPAs (from NBFC sector) and post-Covid hit on productivity, profitability and efficiency – all combined, heavy on EPS. Despite lack of optimism, Budget2021 provided relief on credit pickup (from combination of productive investments and putting monies in have-not’s at the expense of elevated fiscal deficit) and news of Bad Bank & DFI approach for capacity expansion in infrastructure and high sensitive sectors for generation of consumption & employment. It gets heavy beyond 32650-37650 when there’s no clarity as yet on NPAs (inclusive of moratorium book) and profitability (ability to restore FY19 standards).
What Next on India equities is most complex? While comfort remain from US equities, looking up from next round of USD 1.9 Trillion of fiscal stimulus and double-digit India FY22 GDP growth expansion, concerns also play dominant role, both external and internal. Risk from external sector remain from Brent Crude (into $70-85), US 10Y yield (into 1.65-2%) and USD Index (into 96.50-100) and not so from domestic cues with outlook on price stability on 10Y yield at 6.25-6.50% and so is on USD/INR at 73.50-75.
Given the existence of cross-winds and lack of clarity to have decisive directional bias, it would be good to stay fleet-footed, and avoid staying overweight either way – long or short! While hope & optimism remain that 2021 high will be surpassed (with NIFTY target beyond 17350 and Bank Nifty towards 50000), there needs to be resilience at 2020 close & 2021 low (NIFTY at 13596-13981 and Bank Nifty at 29687-31264). It’s good to assume short term consolidation for NIFTY at 13596-15431 and Bank Nifty at 31264-37708 – see over 50% probability for upside break if India macroeconomic turns better to counter external headwinds.
To conclude, the best of fiscal & monetary stimulus is behind and anything more will be stretched & counter productive on the financial markets, making the asset bubble bigger! It would need swift turnaround in growth to redress issues around capacity expansion and fiscal deficit. So, need financial markets to get aligned with real markets in rest of 2021/FY22. There’s hope & optimism, but failure of delivery to expectations will be disastrous…stay with caution & prudence!
Good luck,
Moses Harding
