Three Phases of Monetary Easing

Rate cuts are probably the most overt form of monetary easing, but they are certainly not the only one. Broadly speaking, there are three tools with the central bank: rates, forward guidance, and liquidity. Monetary easing in the current cycle began in early 2015 when the RBI first started cutting rates. However, the initial bout of easing was accompanied with tentative guidance with the central bank presumably still assessing the pace of disinflation ahead. Around mid-year, the guidance evolved to being unequivocally dovish. Thus the second tool of forward guidance started getting deployed to directionally reaffirm the rate cuts. Finally, and after a good bit of lag, the RBI unveiled the third tool of liquidity in the April 2016 policy review; where it explicitly committed to take sustainable liquidity deficit to neutral from its hitherto ‘target’ of 1% deficit on NDTL.

There is a case to be made, and probably with benefit of hindsight, that the three phases could have run in better congruence than they actually did. Thus for instance, market feedback with respect to RBI’s liquidity stance has been forthcoming for some months now. And yet, till very recently the RBI’s push back was that they were controlling the weighted average call rate at levels close to the policy rate and in that sense there wasn’t necessarily any problem with system liquidity. Recognizing this is important for two reasons: One, the lag between rate cuts and transmission could have been compressed somewhat had RBI changed its liquidity stance earlier (for instance in September 2015 when it explicitly signaled its intent to pursue better transmission of rates from thereon). Two, and this is important for the future, the shift now has locked RBI into committed effective monetary easing for the year ahead (better liquidity translating into lower rates is still monetary easing) when it may be argued that we may be approaching at least a minor inflection point with respect to growth and inflation.

A Possible Inflection Point

We have talked about the underlying global macro construct a lot since last year. To briefly recap, the global monetary and fiscal response to the 2008 global financial crisis triggered a new wave of gross capital misallocation most obviously represented by commodity investments made via US dollar leverage. The two pillars underlying this trade were: One, continued US dollar weakening amidst zero bound interest rates and quantitative easing, making dollar loans cheaper. Two, renewed commodity demand led by Chinese stimulus lulling companies into making longer term capacity creation investments. This trend started peaking by 2011 – 12 when dollar index bottomed and Chinese producer price inflation peaked. However, the trend on leverage creation overshot this turning point and only started to unwind when the reversal gained momentum by 2013 – 14. 2014 – 2015 were years of a spectacular manifestation of this unwind when the dollar index started to soar and commodities collapsed to the floor. World-wide disinflation got a massive tailwind as a result and India was no exception.

The point of the above summary is to indicate that these are long period cycle reversals and by no means can be deemed to have played out. Thus the global leverage overhang sustains even now and investment demand across the world is expected to remain weak. These will keep a lid both on commodity prices as well as prospects for global growth for a long time to come. However, there are two underlying points here of vital importance: One, the broad underlying construct described above was true even when oil was at USD 100 per barrel in early 2014. There probably wasn’t a sudden accelerated manifestation of the trend that took oil to USD 30. Similarly, if oil were to rise to, say, USD 60 (already at USD 45) over the next few months, that price move can still be accommodated within the same underlying framework. Thus while the broader framework of lower growth and commodity prices remains intact, there is every likelihood that there may no longer be any incremental disinflation coming from this quarter. Two, and this relates to the first point, one can (and does) get counter-trend moves within an overall longer term macro-construct. There is at least an even chance that we are witnessing something of the sort right now. 2015 was about an accelerated manifestation of the underlying capital misallocation cycle that potentially caught policy makers unawares. What we may be witnessing now is a short term backstop getting created. There are at least three reasons that indicate why this may be the case:

1. US dollar strength seems to have broadly played out for now on the back of some pull back in economic data and with the Fed talking down the dollar. This, on the margin, has eased a big pressure point for global leverage; at least in the short term.
3. China has turned up policy stimulus as being shown directly in their aggregate financing data as well as the resurgent trend in property prices.
4. US oil production is finally declining noticeably after almost two consecutive years of investment cut backs.

These are helping create at least a temporary tailwind to commodity prices with the result that metals, oil, iron ore etc have rallied sharply over the past few months.

The Indian Context

From India’s standpoint as well, and that is really the point of the discussion above, it is worth examining whether we are at an inflection point of sorts. There are again at least three reasons why we think this may be the case:

1. As discussed above the global disinflationary impulse seems to be behind us for now. Barring fresh developments and basis recent policy actions as explained above, it is unreasonable to assume that fresh global disinflationary impulses will support our CPI fall, as they have been doing for the past two years. Indeed, apart from oil and metals, other commodities like sugar and edible oils have also been going up lately; although obviously for different reasons.
2. Rural wages seem to be bottoming out given government’s renewed commitment towards increasing farm incomes and prospects of a better monsoon ahead. Furthermore, urban consumption looks set to also receive a shot in the arm as the central government is slated to implement the Pay Commission recommendations in the next few months. It is to be noted that this will get followed up by states as well as public sector enterprises selectively implementing their own pay hikes as well. Thus all told consumption (rural plus urban) seems set to rebound over the next few quarters. This will naturally raise demand, and in the absence of equivalent supply responses, may risk fuelling some incremental price rise. In this context it must be mentioned that an excessive reliance on monsoon as the trigger for monetary easing risks trivializing the framework of long-term CPI targeting.
3. Finally, RBI policy is also unlikely to contribute towards incremental disinflation going forward. This is because the central bank is now ‘locked’ into a forward commitment to the market to progressively reduce system liquidity deficit to neutral over the course of the next year or so. This means that one can continue to look forward to a grind down in front end rates or, put another way, de-facto further monetary easing over the next few months.

Investor Takeaways

We have preferred to align to a curve steepening view since December of last year (for details please refer to “The Opportunity Set Shifts: A Bond Strategy Update”, dated 22nd December 2015). This trade has been temporarily disrupted since mid-March, largely as pointed RBI OMOs took away a large part of market position within a span of three weeks. However, we think that as we move deeper into the new auction supply calendar, the curve steepening trend will resume. Over and above this, if our assessment presented above proves to be true, market will be faced with two conflicting forces over the next few months: One, as conviction with respect to future sources of disinflation wanes the appetite for long duration will naturally start to get impacted. Two, overnight rates will start setting at or below policy rates consistently versus the earlier regime. This will exert a natural pull to front end rates and improve visibility of roll down available. These forces cumulatively will further help the steepening trade, in our view. Basis this we think investors should continue to align towards front end rates (1 to 5 yrs) through short and medium term products and / or through active managed bond products.