Mutual Funds

Short-term pain, long-term gain

Sandip Sabharwal | Updated on November 24, 2017

Worth the wait

How RBI Governor Raghuram Rajan’s fight against inflation helps bond investors

RBI Governor Raghuram Rajan intends to bring CPI inflation down to reasonable levels in India over the next two-three years.

Trends in US

The move to keep money tight is usually perceived to be negative for bonds in the short run. However, the objective being to tame inflation and inflation expectations, long-term bond investors may laugh their way to the bank, if this is achieved.

The US is a classic example. Subsequent to the inflation spike in the 1980s and early 1990s, a tight monetary policy, combined with an improving fiscal position, led to a fall in inflation from over 10 per cent to an average of 2-3 per cent.

This led to a fall in demand for higher wages and slower rise in product prices, which ultimately led to huge profits for long-term bond investors as bond yields came down. The disadvantage of inflation that remains high for a prolonged period of time is that consumers in the economy expect it to stay high even in the future. The demand for higher wages and the propensity of companies or service providers to increase the cost of their services is also high as they expect future inflation to cut into their profitability and as such most try to pre-empt the same and increase prices.

The disadvantage of prolonged inflation, as evident in India, is that it raises the expectation of high future inflation, which increases the prices of goods and services and demand for higher wages.

A long period of fiscal profligacy, especially in non-productive revenue expenditure, combined with a lack of productivity improvements in large segments of the economy, has kept inflation high for long. The rapid increase in minimum support prices (MSP) of agricultural commodities over the last five years has also contributed to higher CPI.

The weakness of the Indian rupee also contributed to higher imported inflation.

There is now an opportunity for Raghuram Rajan’s gambit to play out. However, this will not be possible without the support of the new Central government.

Continued fiscal profligacy, combined with an increasing propensity to postpone reforms, will lead to slow progress in inflation control. One factor that has also contributed to higher headline inflation has been an adjustment of regulated prices, especially in the power and fuel sectors. These adjustments are almost done now. One big area of adjustment still to be done is fertiliser subsidies. Rajan’s resolve has been received well by the markets and we have seen the debasement in the value of the rupee stop and reverse.

Sharper rally on cards

If we are to assume that the average CPI of 2013-14 of around 10 per cent will fall to 6 per cent over the next two years, this will mean a fall in the 10-year bond yields from the current 9 per cent to below 7 per cent. With an improvement in the economy and fiscal position, the rally in bond prices can be even sharper.

If a zero coupon 10-year bond that yields 9 per cent today yields 7 per cent after two years and has a residual life of eight years, then, for investors who invest today, it will provide a capital appreciation of 38 per cent over a two-year period.

If yields fall to 6 per cent, returns will be a whopping 48 per cent. Essentially a monetary policy that is assumed to be tight and bad for bonds today is actually very good for long-term bond investors if the aim of the policy is achieved.

There will be people who will argue that as US bond yields move up with the end of taper and revival of the US economy, it is unlikely that bonds will rally in India. This is an extremely fallacious argument.

Over the last 15 years, the difference in bond yields between Indian 10-year and US 10-year bonds has been as low as 1 per cent and as high as 7 per cent. The current differential is 6.25 per cent. There is no reason to believe that it will not compress.

Hence, the possibility of a stable growth-oriented government alongside a credible central bank is actually a bullish signal for bond investors.

The possibility of both bond and equity investors making a lot of money over the next two years is quite high.

(The writer is a business consultant )

Published on April 13, 2014

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