High Inflation, Depreciating Currency & Current Account Dynamics
Globally, the month was dominated by rally in crude price, strong US dollar, rising risk-aversion, rapid policy normalisation and growing concerns about recession. Back home, the month was dominated by rate hike, elevated inflation, strong fiscal, protective trade policies, currency pressures and rising concerns about external balances.
After rising sharply to record high level of 7.79%y/y in April’22, India’s headline CPI moderated to 7.04%y/y in May. In fact, May 2022 will be first month in current calendar year that the actual print was in line with consensus (as against the recent trend of higher-than-expected print). That said, inflation print continued to remain above 7% level for second month in row and average ~ 6.8% in first five months of current calendar.
Globally, Inflation continued to remain elevated across countries driven by crude and food. In fact, in countries like US, UK, Euro area, it is at record high levels. In its annual report, the Bank of International Settlement (BIS) has urged for quicker and decisive increase in interest rates to prevent surge in inflation. In fact, the Central Bankers across globe have been raising rates (by larger size with promise for more) & withdrawing liquidity at faster pace to tame inflation expectations.
Pro-long War, broad-based inflationary pressures, front-loading of policy rate, tight financial conditions are raising concerns about demand slowdown and thereby moderation in growth. Several institutions have revised down global and India growth forecast for current year. Incidentally, there is growing concerns about recession in advance economies.
Persistently strong inflation has forced central banks globally to front-load and exercise larger hikes and withdraw surplus liquidity at faster pace. In spite of rising concerns about recession, the focus of policy makers is likely to be on inflation management. In June-22, US hiked the policy rate by 75 bps (150 bps hike since Mar) with indication to hike further by 50 bps each over next couple of meetings. June’22 move was in line with hawkish soundbites from various Fed governors. ECB also indicated to start normalization process from July meeting (earlier than expected) to anchor inflation expectations.
In line with global trends, RBI hiked the repo rate by 50 bps in June-22 policy. Unlike baby steps (25 bps) option exercised pre-pandemic, record high headline inflation print (driven by global cues) compelled RBI to do more (>25 bps hike) and faster (Apr, May, June meetings). RBI revised upward FY23 inflation projection and maintain growth outlook. Despite rising headwinds for growth and tailwinds for inflation, projections seem more in line with consensus expectations and hence realistic. So, while there are lot of uncertainty to outlook, the macro projections gave confidence to the market that the RBI’s future rate actions are likely to be calibrated and measured.
India’s External Sector & Global Update
June-22 saw sharp jump in crude prices on EU sanctions and limited supplies, with crude staying above US120/barrel levels in first fortnight of the month, only to decline to average US$115 in second half on growth concerns. In June-22, crude has increased by 7%m/m, over and above 6% jump in May’22. During 1H CY2022, crude rise has been very sharp (55%). Given uncertainty related, low inventory levels, supply issues and war, the crude prices are expected to remain elevated in coming months
In June-22, growth concerns weighted heavily on other commodities (industrial and agriculture), which saw sharp decline in prices.
In the bond markets, US treasury yields rose sharply across the curve on high inflation and hawkish Fed indicating higher and faster rate hike cycle. The US 10 Yr Treasury bond yield started the month at elevated levels of 2.94% on rate hike expectation and rose further during the month to peaked at 3.49% on higher-than-expected inflation print. Growth concerns helped in easing pressure on yields in second half of fortnight. That said, 10 yr yields remained above 3% lvl for most part of the month. It closed the month below 3% mark at 2.98 levels (May end: 2.85%, Apr end: 2.89%, Mar end: 2.32%, Feb end: 1.83%, Jan 2022 end: 1.79%, Sep through Dec 2021: 1.5%-1.58% range). On risk -off scenario, Dollar Index continued to grow by ~1% m/m in June and even crossed 105-mark mid-month. YTD Dollar index has rose by ~8.6%.
Back home, strong dollar has resulted in lot of pressure on INR on global cues (tight financial conditions, high crude prices, rising current account concerns, FPI outflows), with RBI seen heavily intervening through spot and forward market. While average Rupee was ~78.08 during the month (Avg May: 77.27/US$, Apr: 76.09/US$, Mar: 76.26/US$, Feb: 74.96/US$, Jan: 74.44/US$), there was lot of volatility in rupee movement, with rupee moving from 77.52 at the start of month, crossing 78 lvls in mid-month and jumping to 79 lvls by month end. Going forward, rupee is likely to come under pressure on global cues. Like other emerging economies, India has been witnessing net FPI outflows since Oct 2021 on risk aversion. This trend continued into June. Global financial market volatility saw net FPI outflows of US$ 6.6 bn in Jun (May: US$4.7 bn, Apr: US$3 bn, Mar: US$S6.5 bn, Feb: US$5 bn, Jan: US$3.8 bn) - driven mainly by equity outflows. Since Oct’21, there has been net outflow of ~US$36 bn.
While the 4Q FY22 (Jan-Mar 2022) Current account deficit (CAD) came lower at 1.5% of GDP (3Q FY22 : 2.7%) on seasonality, 1Q FY23 CAD is likely to be ~3% lvls on high trade deficit (driven by commodities primarily oil and gold). High oil prices are raising concerns about high FY23 CAD and reducing gap in real rates is raising concerns about capital flows, thereby about balance of payments. This in turn is putting pressure on rupee, inflation and pushing policy makers to become more proactive (RBI in currency and rate market, while government on supply management by putting qualitative and quantitative restrictions on trade and domestic supply controls).
Yield Levels & Spreads:
Yields rose during the month on inflation concerns, rising oil prices, weak currency, FPI outflows and US treasury yield movement. 10 year G-sec started the month at elevated level of 7.42% and rose sharply up ahead of monetary policy to 7.52%, only to eased a bit post policy on expectations of RBI’s future moves to be calibrated. However, rising crude price, hawkish Fed policy, high inflation, weak currency pushed up the yield to 7.62% by mid-month. The 10 yr yield eased in second half of the month on global cues, improving fiscal finances, sound bites from finance ministry of adhering to fiscal deficit target. It closed the month at 7.45 levels (May end close: 7.42%, Apr end close: 7.12%, Mar end close: 6.84%). 10 Term premium (10 yr over 365 days) eased further during the month to average ~133 bps (May: 166 bps, Apr: 238 bps, Nov-Mar: 222-228 bps range, Oct: 244 bps, Sep: 253 bps, Aug: 259 bps) indicating declining premium and curve flattening on changing RBI pivot.
Like G-sec, 10 yr SDL yields started the month at 7.75%, rose ahead of RBI policy at 7.85%, eased a bit post policy, only to rise on inflation concerns. Like G-sec, it eased in 2H of the month on global cues, and close the month at 7.78% (May end: 7.77%, Apr-end: 7.27%, Mar end: 7.18%). June SDL primary supply stood at Rs.42,500 cr (May: 57,740 cr, Apr : 10,000 cr). The spread between 10 yr SDL over G-sec stood at 30 bps (May :29 bps, Apr: 21 bps, Mar: 35 bps, Feb: 37 bps, Jan: 53, Dec; 47, Nov: 54 bps, Oct: 57 bps, Sep: 61 bps).
Taking cues from G-sec and SDL curve dynamics, AAA bonds yield were volatile during the month. 10 yr AAA PSU started the month at 7.81%, rose to 7.91% pre-policy, only to ease to 7.85 lvls post policy, again to rise further on inflation concerns. Like G-sec, it eased in 2H to close the month at 7.89% (May end: 7.89%, Apr end: 7.35%, Mar end: 7.05%).
- We are of the view that policy rate may reach 5.15% levels by Aug’22 policy (as indicated by RBI in May’22 policy) and 6% by year end, with market expecting it around 6-6.5% depending upon inflation trajectory. RBI’s quarterly inflation projections indicates the intermediate levels around 6% levels.
- With system liquidity coming down and pickup in credit off-take, the corporate spread is likely to increase in coming period. So, while rate markets might increase by 20-30 bps over period, the spread market might increase 25-30 bps over and above that.
- While the shorter end of the curve is linked to policy rate and system liquidity consideration, it is already repriced in the levels and may settle down in coming days. Longer end of curve, although has repriced the policy rate actions, may however continue to remain volatile owing to demand-supply mismatches, worries around fiscal concerns (if materialize) and willingness of RBI to intervene (in terms of quantum and timing).
RBI, CEIC, Bloomberg, CCIL, US Federal Reserve, ECB, Finance Ministry of India
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