More pronounced signs of economic breakage

It is evident now that economic growth is slowing appreciably around the world. While this is widely acknowledged by now, one suspects the extent of the eventual slowdown is still not. There seems to be momentum to the slowdown given the context of more restrictive fiscal policy now and the fact that central banks will widely keep monetary conditions tighter for longer.

While China is loosening policy on the margin, there are multiple constraints here both on the quantum of easing possible and the net effect of the same. Thus the only (temporary) respite to the downward momentum to global growth could potentially be from a possible cessation of war and a consequent sharp correction in energy prices (this is mentioned as a possible scenario here and not a view).

Barring that, one would expect the higher momentum data slowdown to eventually feed into the 'stickier' parts of the world economy. As one example of this, concurrent data on US housing sales has turned down significantly. Signs that this is percolating into new construction are very much there. One would think it a matter of time that the housing slowdown starts showing up in house prices and from there as a negative wealth effect for consumers. This in turn may weigh further on discretionary consumption (including for services) which is already slowing. The construction slowdown alongside the ongoing manufacturing weakness would show eventually in the labour market and from there into wages.

The last of these is the slowest moving piece in the chain just described. However this is precisely the shoe the Fed is waiting to see drop, and that is the reason that policy rates will have to be held higher for longer. An implication of this also is that while sovereign rates may already have done the heavy-lifting, corporate bond spreads in developed markets (DMs) appear way too sanguine given the macro context described here.

One can think about India's own growth momentum in context of slowdown spreading to stickier parts of the world. We have two distinct advantages going for us.

One, a long period issue on local corporate and bank balance sheets is now behind us. This has been a significant cyclical drag over the past many years which has now turned into a tailwind.

Two, India's total monetary and fiscal policy response to Covid has been measured and responsible. This implies that there is very little overhang to deal with of excess stimulus from the past unlike in the case of many developed economies. This is also the main reason behind our view that India needn't follow the US lockstep in monetary tightening and that we can afford for our effective overnight rate to peak below 6 per cent in this cycle.

Returning to point, however, the cycle and policy tailwinds are ensuring that we now grow more robustly than many other nations around the world. The relative growth advantage will likely sustain going forward. However, the absolute growth acceleration that we have witnessed over the past few months will have to slow reflecting the weakening global growth. This starts through the export channel, as it already has, and then proceeds to impact local consumption and investments down the line.

Tighter global financial conditions and possible implications

While DM sovereign rates may be more range bound from here, this doesn't mean that we are done with tightening in global financial conditions. As rates stay tighter for longer in the face of economic breakage, this may get evidenced more in the usual risk off trades like stronger DM currencies and wider corporate bond spreads (DM corporate bond spreads are still relatively well behaved and seem to have significant room to expand). Many emerging market (EM) bond yields are also like 'spread' assets for global capital. Thus a tighter for longer policy environment in DMs will entail stricter financial conditions and hence a widening of spreads. This may impact yields in many EMs as well.

Over the first half of the year when the world was readjusting its expectation of global monetary tightening, the linkage to Indian bonds was largely through interest rate swaps rather than outright bond selling by foreign investors in a big way. Most of the capital outflows were instead from the equities markets. This probably reflects the fact that active foreign interest has been missing from Indian bonds over the past few years and hence the amount of rebalancing out may also consequently be lower. Portfolio rebalancing on possible another bout of risk aversion ahead may not impact India's bonds significantly. Also with spread between bond and swap having opened up (5 year government bond yields were around 60 bps over 5 year swap yields at the time of writing), there is room for this to compress without significantly impacting underlying bond yields.

However, this doesn't mean that local bonds are immune to global financial conditions tightening. This needs to be still respected, in our view. As an example, lately the local bond market is abuzz with expectations that India is on the cusp of being included in at least one of the large global sovereign bond indices. The argument heard is that this time around this is on 'pull' from investors desiring some diversification to their EM exposures. Hence it may go through even without associated facilitators that required leeway on taxation which apparently our policymakers were against. The expectation is that the while flows associated with actual index inclusion may take some time, and the weight assigned to Indian bonds in the index itself would only gradually go up, other 'fast money' flow may pre-empt this and already start coming in. Basis this expectation, one has seen a bull flattening over the past few sessions thereby further flattening the 5 to 10 year yield spread, as local participants have taken positions in longer duration bonds anticipating this announcement.

We have no idea how far this can stretch in the near term. However, nothing changes to our underlying view that if there's one point of concern that bond markets ought to have over the medium term, it is the amount of duration supply. This is both on account of higher than pre-pandemic averages on likely fiscal deficit over the next few years as well as a shift higher in annual bond maturities over the next many years from what was the case in the past. Even adjusted for nominal growth in participant balance sheets, this is a significant step up in duration supply and likely needs support from a demand standpoint. Absent offshore investors, RBI would have eventually stepped in to buy bonds as a means to expand its balance sheet. With index inclusion, offshore investors will buy bonds and RBI will get the dollars to expand balance sheet. Then RBI wouldn't need to buy bonds. Either way, over the medium term, the eventual effect on bond yields may be similar.

Thus the issue of duration absorption may still persist after the initial euphoria on index inclusion subsides. Also this would be in what is a tighter global financing environment. In India too even as our peak rate expectations are in place, we would expect RBI to hold them there for longer. Thus investors should continue to want higher risk premia from yields for holding higher duration over the medium term. Also given how unforgiving the global environment is, we don't want to be too 'tactical' with our portfolio strategies by trying to chase the bull flattening. All told then, we continue to find the most value in 4 -5 year government bonds.

(Suyash Choudhary is Head, Fixed Income, IDFC AMC)