Bond Markets run ahead of Central Banks. Time to allocate to Indian Bonds.

The US treasury secretary John Connally proclaimed at the G-10 meeting held in Rome in late 1971- “The dollar is our currency, but it’s your problem”.

50 years have passed since, but the movements in the US dollar continue to worry policymakers across the world. The US economy is about a quarter of the world GDP. The US Dollar is used for the settlement of over 40% of all international trades and it accounts for about 60% of total central bank reserves worldwide.

Thus, whatever the FED does to the US interest rates and hence its impact on the US Dollar has repercussions for the entire world.

It gets even more troubling, at a time when the Federal Reserve (FED) is fighting the highest inflation in the US, in 40 years.

FED’s inflation fight

On June 15, 2022, the FED hiked the federal funds rate (the interest rate at which commercial banks borrow and lend their overnight excess reserves) by 75 basis points, the largest one-off rate hike since 1994.

Since March this year, the federal funds rate has been raised by a cumulative 150 basis points from the range of 0%-0.25% to 1.50%-1.75%.

CPI inflation in the US is still above 8% and the US economy is creating about two jobs for every single person looking out for a job. So, the FED has every reason to continue hiking rates till they get inflation under control. To recall, the FED targets to keep inflation at 2%.

As per FED’s own projection, the federal funds rate will be at 3.4% by December 2022. This implies another 175 basis points rate hike over the next six months.

Alongside, the Fed has also started the process to reduce its gigantic USD 9 trillion balance sheet by letting the bonds in its portfolio mature and not reinvest the money. The pace of balance sheet runoff is set at USD 47.5bn per month until September when it will ramp up to a total of USD 95bn per month.

At this pace, FED’s balance sheet assets will fall by USD 1.6 trillion by the end of 2023. This means the Fed will take away USD 1.6 trillion of liquidity from the global financial system.

We all know how lower interest rates and a flood of global liquidity have helped risk assets like equities and long-term bonds over the last many years. So, reversal of these conditions would obviously have a negative impact on these assets.

This year, as of June 17, 2022, the US equity index S&P 500 is down 23%; during the same time, the 10-year US treasury yield is up 171 basis points (1%=100 basis points). The Bloomberg US Aggregate Bond Index which comprises US treasury and investment-grade bonds, is down 11.5% in absolute terms, year to date.

A similar trend in equities and bonds performance can be seen across all major economies. In India, BSE Sensex is down ~12% and the 10-year government bond yield is up 110 basis points. The Crisil Composite Bond Fund Index is down 2.3% in INR terms and down by about 6.9% in USD.

Peak Inflation Narrative

The mood on street is extremely pessimistic. The pace at which the FED and many other central banks are moving has frightened investors.

At this point, the biggest question on top of the investor’s mind is – How far will the FED go?

The FED expects that a FED Funds rate averaging 3.5% over the next 2 years will be enough to get inflation back to its 2% range with some growth sacrifice but no major increase in unemployment. This is what they term, a soft landing.

While on the other hand, if PCE inflation (FED’s preferred measure) falls only to say 4% in 2023 from the current levels of 5.5%, it would force the FED to hike way more than current expectations and tighten its balance sheet at a faster pace forcing the economy into recession. A hard landing.

So, the simple answer to the above question is that we don’t know. And neither does the Federal Reserve nor the Reserve Bank of India.

Times are uncertain and hence, investing has to accommodate probabilities, some base assumptions, and the ability to react. And it is necessary to remain objective during this volatile time.

As things stand now, it seems that the narrative around the inflation fight, and the monetary policy tightening is peaking now, though the FED has to catch up with it.

The bond market has built-in significant uncertainty premium. So, if things do not worsen from here, we may see the global bond and currency markets stabilising or possibly improving from current levels.

What does this mean for Indian Bonds?

Monetary tightening (liquidity withdrawals and rate hikes) in the developed world typically causes capital outflows from emerging markets (EM) and puts pressure on EM currencies, which then transmits to the domestic bonds.

In the 2022 year till date (June 17, 2022), the Dollar Index has risen by 9.44% while the INR has weakened against the US dollar by only 4.57%. Consequently, the INR has appreciated against most of the major currencies during this period.