Escalated Geo-political Risks: Inflation Pre-ponderance over Monetary Policy
The month saw rising concerns about demand slowdown from China (Virus and related lockdown, moderation in growth projections) thereby raising concerns about global growth. At the same time, lingering supply issues (extended war, volatility in commodity and financial markets) resulted in sharp increase in inflation across globe with sticky/persistent nature of its outlook. In this backdrop, Central banks (both advanced and emerging economies) are in aggressive tightening mode along with rapid liquidity normalisation via quantitative tightening (QT) mode.
With Russia-Ukraine war running into third month and seems unlikely to close soon thereby leading to rise in geo-political uncertainty, supply chain issues, across board record high prices, growth concerns in China, record high inflation and tight monetary and financial conditions. This in turn has led slowdown in overall global growth momentum. International organisations (World Bank, IMF) have sharply revised down the growth forecast for CY2022. According to IMF, global growth in 2022 is forecast to be around 3.6% (Jan 2022 estimate: 4.4%), with emerging economies likely to take major hit. China’s growth forecast has been revised down to 5.1% (Jan 2022: 5.5%), while Indian economy is projected to grow at 6.9% (Jan 2022: 7.7%).
March 2022 inflation for India came in as a shocker with headline print at 6.95%y/y (Feb 2022: 6.07%y/y). This was much higher than the consensus estimates of 6.4% y/y. Sequential momentum in headline was much higher than the seasonality and was broad-based indicating direct and indirect pass-through of rising crude prices and supply issues. Core inflation rose sharply to 6.52%y/y (after remaining ~6.20% lvls between Oct 21-Feb 22).
Headline number is now almost 1% over the higher bound of RBI’s target range and expected to remain around similar levels in Apr’22 on worsening global macros (high and elevated commodities, lingering supply chain issues) and domestic factors (rising cost of production, pick-up in demand). With March quarter average at 6.4% and June quarter expected ~6% plus on rising prices, the pressure on RBI to act is rising.
Globally, the inflation has been at elevated levels over last couple of months, with March numbers across economies reflecting sharp increase on back of crude oil shock. With extended war between Russia and Ukraine, supply side issues are likely to be exacerbated for extended time, making higher inflation more entrenched. IMF, in its latest outlook, has sharply revised upward inflation projections for both advanced and emerging economies.
Reflecting its emerging dynamics, RBI, in early April-22 policy, while keeping key policy rate unchanged, started with its normalisation process by increasing the lower end of LAF corridor to 3.75% (from 3.35% since start of pandemic). Amid rising uncertainty related to geo-political risks & its global spill-over, RBI revised down FY23 growth projections (60 bps) and sharply raised inflation projections (120 bps). It restored the LAF corridor to pre-pandemic levels. Further, it also asserted that inflation will henceforth take precedence over the growth unlike pandemic times. It has moved from ultra-accommodative policy to accommodative policy. Further, with rising inflation risk rapidly, RBI in its off-cycle meeting in early May’22, decided to hike the key policy rate by 40 bps with clear indication front-loading the rate hikes and embarked on the path of aggressive liquidity normalisation (via CRR hike of 50 bps).
Globally, most central banks have already embarked on the path of normalisation with most emerging economies taking lead. Now with inflation risk lurking in backdrop of rising geo-political risks, monetary policy tightening is being followed by vigour (with India recently joining the club). Many advanced economies have started process of rate/liquidity normalisation. After hiking the rate by 25 bps in March-22, the Fed Governor hiked the policy rate by 50 bps in early May’22 meeting and mentioned 50 bps hike is on table for next couple of meetings. It also announced its quantitative tightening (QT) programme, with early start of Fed balance sheet contraction from June 1, 2022. After hiking the rate in every policy meeting since Dec 2021, Bank of England hiked the rate by 25 bps in May’22 meeting on record high inflation (March print: 7%). Euro Area is also witnessing sharp rise in inflation due mercurial rise in fuel prices and early indication from policy makers are for July/Sep hikes. With most Advanced economies now in normalisation camp, only Bank of Japan preferred to look at the inflation shock as temporary and preferred to remain accommodative.
India’s External Sector & Global Update
Crude prices remained elevated and volatile on geo-political & growth concerns. While they declined by 8%m/m to average ~US$105.8/barrel (Mar: US$115.6/barrel), they continued to remain above US$100 mark for most part of the month. YTD CY22 crude rise has been sharp (37%). Given uncertainty related, low inventory levels, supply issues and war, the crude prices are expected to remain volatile as well as elevated in coming months.
In the bond markets, US treasury yields rose sharply during the month on account of record high inflation print, hawkish Fed speak, elevated crude prices and geo-political risk. The US 10 Yr Treasury bond yield started the month at 2.39%, touched 2.93% levles mid-month, only to ease a bit to close the month at 2.89% (Mar end: 2.32%, Feb end: 1.83%, Jan end: 1.79%, Sep through Dec: 1.5%-1.58% range, Aug end: 1.3%, July end: 1.24%). On risk -off scenario, Dollar Index continued to rise robustly by 2.2% m/m in Apr’22 and cross mark of 100. In fact, it touched record high 103 towards end of month on rise in risk-aversion. YTD Dollar index has rose by ~5%.
Back home, INR stabilised during Apr’22, after being in depreciating mode since Feb on back of sharp rise in geo-political tensions (Avg Apr’22: 76.09/US$, Mar: 76.26/US$, Feb: 74.96/US$, Jan: 74.44/US$). Going forward, rupee is likely to come under pressure on global cues. Like other emerging economies, India has been witnessing net FPI outflows since Oct 2021. This trend continued into Apr’22. Global financial market volatility due to Russia-Ukraine conflict saw net FPI outflows of US$ 3 bn in Apr’22 (lowered than witnessed in Mar: US$6.5 bn, Feb: US$5 bn, Jan: US$3.8 bn) - driven mainly by equity outflows. Since Oct, there has been net outflow of ~US$24 bn. After a sharp decline in March (US$14 bn), the month saw decline of~US$6 bn in forex reserves to US$600 bn by third week of Apr’22. However, auction and maturity of forex swaps (US$10 bn) might have likely to led higher drain to forex reserves by month end.
Yield Levels & Spreads:
Yields moved up sharply during the month post RBI policy in early Apr’22. RBI has changed its stance and hiked lower bound of LAF corridor. The 10 Yr benchmark started the month at 6.90% (Mar end close: 6.84%), jumped to 7.12% (on higher than expected increase in lower bound of LAF corridor), rising further to 7.23% on higher than expected inflation print and close the month at 7.14% on global cues. 10 Term premium (10 yr over 365 days) stood on average ~238 bps (Nov-Mar : 222-228 bps range, Oct: 244 bps, Sep: 253 bps, Aug: 259 bps) indicating steepness of yield curve.
Like Gsec, 10 yr SDL yields rose post RBI policy in early Apr’22. It started the month at 7.19 lvls, rose to 7.35 post policy, touched 40 lvls post inflation print and thereafter eased and remained range-bound to close the month at 7.27% (Mar end : 7.18%, Feb end: 7.10, Jan end: 7.24, Dec end: 6.99%, Nov end: 6.81%, Oct end: 6.92). 10 yr SDL was on average ~7.29% (Previous: 7.18%). Apr’22 SDL primary supply was miniscule at Rs.9,500 cr on robust revenue collections (Mar : 1,03,665 cr, Feb : 52,118 cr, Jan: 79,535 cr, Dec: Rs.54,385 cr, Nov: Rs. 43,502 cr, Avg Aug-Oct: 55,000 cr). The spread between 10 yr SDL over G-sec eased to 21 bps (Mar : 35 bps, Feb : 37 bps, Jan : 53, Dec; 47, Nov: 54 bps, Oct: 57 bps, Sep: 61 bps, Aug:71 bps).
Taking cues from G-sec and SDL curve dynamics, AAA bonds rose post policy. 10 yr AAA PSU started the month at 7.03%, rose to 7.20% post policy and jump to 7.33% post inflation print and close the month at 7.35% (Mar end : 7.05%, Feb end: 7.02%, Jan end: 7.10%, Dec end: 6.84%, Nov end: 6.88%, Oct end: 6.91%, Sep end: 6.80%, Aug end: 6.93%).
- Normalisation of Liquidity Adjustment Facility (LAF) corridor via hike in lower bound of LAF corridor (in Apr’22 and now surprise rate hike by RBI (in early May’22 policy) has clearly indicated policy of normalisation has begun in India. Especially May’22 hike is clear indication of front-loaded and aggressive nature of policy. Now inflation has taken clear precedence over the growth and based on evolving inflation trajectory, June-22 and August-22 seems like live policy. As a result, post surprise May’22 rate hike, yield curve across curve rose sharply by around 25-40 bps reflecting to hawkish nature of policy. Further, we believe market reaction is primarily to not just 40 bps hike repo rate, but its front-loaded nature and hence would likely to remain volatile over next couple of days before stabilising.
- In early May’22 meeting, the US Fed hiked the key policy rate by 50 bps (in line with market expectations). Further, it decided to kickstart QT (quantitative tightening) from June 1, 2022 (early start) by adjusting reinvestment of securities. Normalisation process (rates and liquidity) of US Fed has already started impacting yields and flows to emerging markets (including India). While the latest move was already anticipated by the market, the market will watch out of future rate & QT trajectory and sound bite from US Fed.
- That said, the evolving geopolitical risk maycontinue to be determining factor for growth, inflation, fiscal, trade, currency, supply chain and financial market outlook.
We believe with front-loading nature of RBI’s rate hike and aggressive normalisation approach globally, Indian fixed income market is likely to remain volatile with selling bias in coming days, with selling bias on every rally till market stabilise.
Bloomberg, RBI, CEIC, Finance Ministry of India, NIMF Research
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