Prime Debt outlook 2023: Handling a rate pause

After bungee jumping off a cliff, it is good to wait for the adrenaline rush to wear off. Indian bond markets are in exactly this situation now. After falling sharply as rates rose, bond prices are pausing to take a breath. In our debt outlook last year we expected rates to continue their upward climb and recommended strategies to play this. During the course of 2023, we think interest rates could top out and stabilise. We tell you what this will mean for your debt portfolio.  

Official rates  

After nervously watching inflation and dilly-dallying until the first quarter of the year, India’s MPC (Monetary Policy Committee) began to raise the policy rate from April 2022. Once it began, it decided to go the whole hog, hiking the repo rate (the overnight rate at which banks borrow) all the way from 4% to 6.25% over the next eight months. The repo rate, at 6.25% now, has overshot its pre-Covid level of 5.9%.  

So, will the MPC continue with its rate hikes from here and how far will it go? The MPC has (wisely) refused to stick its neck out on where its rate hikes will end and has said that this will be data dependent. We at PrimeInvestor believe that the MPC may take perhaps one or two more rate hikes in the first half of 2023, before going for a pause. The following facts make a case for a pause: 

• In the US, the gap between the US Fed’s target inflation rate (2%) and the actual inflation rate (7.1% in November) is huge. But the gap has been narrowing in India. The MPC gets very uncomfortable with inflation only if the CPI inflation rate is above 6 per cent for two quarters running. In India, CPI inflation has fallen to 5.88% for November after moderating steadily in previous months. The RBI in its recent monetary review forecast that while CPI inflation may average 6.7% over the whole of FY23, it expects it to cool from 6.6% in October-December 2022, to 5.9% by January-March 2023 and to 5.4% by July-September 2023. If actual inflation prints follow this trajectory, the pressure will off MPC to continue rate hikes without a pause.
  Recently, the easing of global supply chain issues and fuel prices due to recession worries have led to lower imported inflation in India. The spike in food prices especially in cooking oils and vegetables has also abated due to improving supplies. The winter months usually mark falling fruit and vegetable prices. The good monsoon has lifted the kharif harvest as well as rabi prospects. All this suggests that inflation trends in India may turn more moderate in 2023. This may offer room for the MPC to take its foot off the pedal after one or two more hikes.  

• In the US, the Fed is mainly worried about a tight job market fuelling a wage-price spiral that turns inflation into a vicious cycle. India is at limited risk of inflation turning sticky for this reason. A wage-price spiral is a situation where rising income fuels more demand and price rise. The price rise in turn bolsters business profits and leads to further wage hikes. This fear is what makes the Fed so determined to slow down jobs growth and even risk a recession in the economy, to control the current bout of inflation. In India, the job market is not in great shape with unemployment rates at 7-8% and low-income earners have been hard hit by Covid, so there’s little risk of a wage-price spiral. The recent bout of inflation in India was mainly caused by the global spike in energy prices and supply chain disruptions caused by the Russia-Ukraine conflict and China’s lockdown. 

• The above factors may prompt RBI and MPC to take a less dire view of inflation in India, prompting them to weigh the negative impact on growth while taking their rate hike decisions in 2023. India’s latest GDP data for the July-September 2022 quarter showed a material loss of momentum in the Indian economy with growth slowing to 6.3% and key sectors such as mining and manufacturing actually contracting.  Most global agencies have been busy lowering India’s growth forecasts for 2023, apprehending an impact from the global recession, the fading away of post-Covid revenge buying and the low base effect. With the economy expected to grow below potential at 6.8% in 2023, the MPC will be wary of going overboard with rate hikes and pushing the economy into a further slowdown. Upcoming general elections in 2024 will also act as a deterrent to overly hawkish policies. 

• Studies show that repo rate hikes in India usually take a minimum of two quarters to get transmitted to the economy. Having put through rate hikes of 225 points in a short period of eight months in 2022, MPC may like to pause and see the impact of past rate hikes on inflation and growth, before going on a further rate hiking spree. RBI’s recent MPC minutes show that at least two of the six members have been resisting continued rate hikes in recent meetings, flagging concerns that hiking too much too fast would hurt economic growth. 

• While it was earlier believed that rate hikes by the US Fed would force MPC’s hand in raising rates, this theory has been challenged in 2022. Though the US Fed hiked rates sharply and narrowed rate differentials with India, FPI flows did not play out according to the script. FPIs did pull out over Rs 2.3 lakh crore from Indian bonds and stocks in the first half of 2022 (more from stocks than bonds, surprisingly). But from July 2022, with other emerging markets looking more dicey, they returned to India investing Rs 92,700-odd crore in stocks and bonds from July to November 2022. Returning FPI flows offer some room for the MPC to pursue rate policies that are independent of the US Fed.  

The above factors suggest that India’s repo rates may not rise more than 35-50 basis points from current levels in 2023. However, this view is based on current data and can change dramatically if there’s an FPI exodus or a resurgence in geopolitical tensions that again resurrect supply chain issues or lead to an oil price flare-up.  While the repo rate may stabilise in 2023, cuts are quite unlikely. As long as the Western world led by the US Fed pursues hawkish policies, the MPC will not like to risk shrinking rate differentials by reducing domestic policy rates. 

Market rates

Like stock prices, bond prices also tend to factor in events before they happen. Therefore, India’s market interest rates had begun to chart an upward trajectory much before the MPC undertook its repo rate hikes from April 2022. The 10-year government security (g-sec), the most actively traded bond in the market, began its upward climb from a low of about 5.7% way back in July 2020. It climbed steadily for two years to hit a high of over 7.62% by June 2022. Since then, it has hit a barrier and seen two-way gyrations. 

Going forward, we believe that the 10 year g-sec yield may have limited upside left as it has run ahead of official rate hikes. Though the 10-year gilt has topped 8% in the previous rate cycles in India, this has been during periods of robust economic growth. Over 2023, slower growth, normalisation of the fiscal deficit post-Covid and the lure of possible inclusion of Indian sovereign bonds in global bond indices may cap the rise in market yields. The 10-year gilt may continue with its two-way moves between 7-7.5% through 2023. It may take unpleasant surprises on the CPI inflation number, another outbreak of global hostilities (say China-Taiwan), oil shock or a sudden FPI exodus to take the yield beyond this range, closer to the 8% mark. Given that calling such events or a top in rates is next to impossible, investors should look for opportunities to lock into higher duration debt whenever the 10-year approaches 7.5%. 

In April 2022, we pointed out (in our article how to ride the interest rate upcycle) that while interest rates on long-term gilts were the first to move, rates in the rest of the market may catch up soon. This has played out as expected. Over April-December 2022, yields on 1-year, 3-year and 5-year gilts have shot up much more than that on the 10-year g-sec. As repo rate hikes came through, yields on very short-term bonds have raced to catch up too. In fact, it was treasury bills and commercial paper that saw the steepest rise in yields between April and December 2022. 

Your debt strategy

With corporate credit offtake taking its own time to perk up, yields on corporate bonds especially AAA rated ones remained lacklustre until mid-2022. But the yield catch-up has lately been happening in this segment too with business activity revving up. The above table shows that yields on corporate bonds (3 to 5 year) have spiked by 120-180 basis points in the last eight months. But yields on corporate bonds rated AA and below have risen at a slower pace than AAA bonds or sovereigns and there may be some catch up left in this space. Based on the above view, we recommend the following debt strategies for investors in 2023: 

• Parking temporary surpluses in treasury bills given their high yields. If you don’t have a RBI RDG account, you can consider FDs from highly rated banks, small finance banks and NBFCs. There’s no longer a need to stick only with systemically important banks or small savings schemes which offer uncompetitive rates. You can spread it to other options. Use Prime Deposits for recommendations.  
• Parking less than 3-year money in money market, short term debt funds which now offer better return prospects owing to the improved yield to maturity on their portfolios. (You can refer to this earlier article on debt fund strategies. 
• Parking 5 year plus money in target maturity debt funds that combine gilts with SDLs. 
• Allocate some of your debt fund money to credit risk funds that invest in AA and A rated bonds, which now offer good risk-reward. You can use Prime Funds to choose credit risk funds (available in the 5-year plus debt category)
• Look for spikes in the 5 year or 10-year gilt yields to 7.5% or higher and use the opportunity to lock into constant maturity debt funds, 5-year or 10-year gilt passive funds. This option would be suitable for money you can spare for five years plus set aside towards long term goals such as children’s education or retirement that are over 5 years away. 
• Watch out for our recommendations on public offers of NCDs and privately placed bonds in the secondary market where we have already begun to fish for attractive high yield opportunities. Growth subscribers can read our recent calls in this space here : Prime Bonds.