July 16, 2013
The yield curve should get very inverted. Tightening measures should push up short term rates sharply while the damage done to the real economy auger well for long term rates. Remember, IIP is de-growing and GDP growth is at a decade low. I hope the OMO is done in very short term securities to ensure long term rates don’t spike. The government borrowing program is heavy. Higher short term rates may attract some FII flows but hope that these measures don’t scare the equity investors as to desperate and ad-hoc response to the economic crisis. Given the history of reforms happening in a crisis time, particularly when currency is under pressure, I expect government to announce other important reforms in the areas of FDI and infrastructure build up rather than tackling the crisis week on week and being so reactionary.
If we look back in history, episodes like 1997 Asian crisis and July 2008, these extreme monetary measures are very short term in nature. Call money rates spiked to 100% in 1997 but it led to a severe slowdown which resulted in the biggest bull market in bonds. After the rate hike in July 2008, RBI went overboard in cutting rates and releasing liquidity and 10-year yield fell more than 300 bps in a matter of few months.
We have lightened duration in long term bond funds over the last few weeks with over 35% of the portfolio in cash and money market instruments but our bias would be to add duration if prices fall more.
Bonds yielding above 8% in an economy which is substantially below potential growth rate and in a world which is very deflationary are good bets. Similarly, the initial reaction of equity investors would be very negative, but they have been mainly concerned about the movement in Rupee which should now stabilize. Both equity and bond markets would react negatively with strong feedback loop but this will throw good opportunities for investors who have longer horizon and patience.