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Growth/inflation dynamics have remained volatile on account of the continued geo-political shocks, supply chain re-alignments and erratic weather patterns in recent times, influencing interest rates
The yield on the US 10-year treasury benchmark — the global bellwether for fixed income — stood at 3.30 per cent in April 2023, post the regional banking crisis when concerns about market stability were at their peak . It surged to 5 per cent in October 2023 on account of the uncertainty of the US monetary cycle before going back below 4 per cent post the Fed pivot in December 2023. Then, it once again sold off to 4.4 per cent as market participants prepared for a shallow rate-cut cycle.
Indian bond yields, though, were relatively stable and traded in a narrow range of 7.10-7.30 per cent for most of last year as Indian macro indicators (fiscal, inflation, CAD) were well-behaved. Moreover, the RBI has been exemplary in its consistency in its forward guidance and conduct. It has demonstrated an unwavering focus on ensuring that inflation is stable and close to its medium target of 4 per cent before it moves towards reducing policy rates.
Into 2024, while Inflation may remain above the long-term targets of global central banks, they will have reasonable policy space to cut interest rates, given the preceding series of aggressive rate hikes.
However, for India, barring an economic shock, rate cuts are likely to be moderate, with inflation expected to average 4.5 per cent in FY25 compared to RBI’s target of 4 per cent. There is a base case for 50-75 bps rate cuts in India in CY24.
Implications for debt investors
The first step for investors is to decide their allocation to fixed income, which may depend on their risk appetite and time horizon. Once the allocation decision is made, conventionally, the usual port of call for investors — when they foresee rate cuts — is to invest in high-duration strategies (5 years +) to maximise their capital gains.
While it makes conventional sense and may even give immediate gratification in the near term, it may lead to sub-optimal outcomes in the medium to long term if the nature of the rate-cut cycle is not understood carefully.
Typically, rate cuts undertaken in response to an economic shock — such as the Covid-19 pandemic or the 2008 Global Economic Crisis — are deep, to revive growth, and are constructive for a long duration. However, rate cuts in response to a moderate slowdown in growth or cyclical slowdown in inflation can be shallow and may not result in meaningful capital gains for a long duration.
Moreover, what also matters for financial markets is the “surprise” element against consensus. Since markets work on a forward-pricing mechanism, the current market construct may discount a part of future rate expectations. In other words, some of the gains have already been made in anticipation.
With this in mind, we tried to assess bond market behaviour in previous rate-cut cycles.
In the accompanying tables, we have tried to capture market levels six months before the rate-cut cycle (first rate cut) and six months after the rate-cut cycle (last rate cut) to account for “market expectations”. The tables compare the three-year AAA spread to overnight rates and a 10-year G-Sec to overnight rates (one-month OIS has been taken as a proxy for overnight rate to account for an operative rate below repo in periods of easy liquidity )).
As can be seen from the tables , the spread between 10-year G-Sec and overnight rate (called the term premium) typically goes up after the rate cuts, as market positioning unwinds and then the term premium gets established on concluding policy rate. However, the spread between three-year bonds and overnight rate comes down as the shorter end of the curve waits for the appropriate pricing of the concluding policy rate and the overnight rate goes down.
A similar dynamic played out during the previous rate hiking cycle. The 10-year yield peaked at 7.62 per cent in June 2022 when the repo was just 4.90 per cent (Source: Bloomberg). This happened despite RBI carrying out an additional 160 bps rate hike as market participants had started to price in the terminal policy rate once RBI had initiated the hiking cycle. The rest of the hikes did not have the “surprise”.
Where to invest
Given this backdrop, where should investors put their money now? Those who have an investment time horizon of more than 12 months may be better off selecting a moderate duration product (2-4 years), categories such asshort-term funds, corporate bond funds, etc., from a risk-reward perspective. They can, hence, benefit from a starting level of high yields as well as from the possible mark-to-market gains once the rate-cut cycle commences.
Around the same time last year, there were widespread expectations amongst market participants of the global economy slowing down on exceptionally high interest rates and central banks cutting policy rates in late 2023. However, as the year went on, market participants realised that economic growth had remained stable and that the rate-cut cycle may get delayed. Given their high accrual, moderate duration products may still be contemplated even if the rate-cut cycle is delayed.
The writer is Head of Fixed Income, UTI AMC
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