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India Strategy: Bull flattening trade exaggerated

India yields mimicking global move, domestic factors less of a contributor

The bull flattening in India yield curve (10 year at 6.30-6.5% is mimicking the US treasury curve). Of the 100bp decline in 10-year Gsec yield since Mar 2019, domestic factor contributed mere 20-30bp. Bulk of the balance 70-80bp reflects expected cut in Fed rate in excess of 100bp.  Since we assess a cyclical slowdown rather than a US recession, we believe the Gsec market too is over-pricing rate easing by the Fed. An unwinding of this expectation could cause 10-year Gsec to reverse to over 7.0% in the near term, in our view.

Building in multiple layers of self-fulfilling expectations  

With INR/USD forward premium at 4.5% and the 10-year Gsec yield at 6.5%, yields lesser than the US 10-year treasury imply expected shrinkage in forward premium. Since the market may have already priced in over 100bp Fed rate easing, RBI’s cuts will have to outpace those of Fed by a significant margin to create a decent yield for India’s sovereign bond rating. This proposition looks risky, as it builds in multiple layers of self-fulfilling expectations. We believe the current forward premium is fairly priced.  Hence, it is likely that India’s Gsec yields could harden to compensate for the forward premium.

The Fed may belie market expectation

In contrast to the rising pressure on the Fed to cut rate, most rule-based models do not suggest deep rate cuts. Fed’s target rate of 2.25-2.5% is more or less in line with modern Taylor rule model’s estimated neutral rate of 2.2-2.3% (just 10-20bp lower than the current effective Fed rate of 2.4%). Worked inversely, for a 100bp rate easing, the core inflation rate will need to decline to 0.6-0.8% from 1.6% currently. Hence, we believe the spill-over effect of shock of US-China trade conflicts would be the only factor justifying even a 25bp cut in Fed rate in the near term.

Global trade remains weak; could stabilise after initial shocks

Various rounds of US sanctions on China goods have triggered sharp drop in global trade since Oct 2018, which is the genesis of bond curve inversion. Overall, bond markets are pricing in recession, which is an exaggeration, in our view.  China-US trade negotiations are central to the global economy and going forward, we see fair likelihood of the acrimony on both sides to recede. Given the highly accommodative financial conditions across major markets, additional measures from Fed and other central banks will be of little relevance, as trade conflicts have a structural character.

Rate sensitive stocks vulnerable

Continued bull-flattening and decline in risk-free rate caused India benchmark indices to re-rate, led by financial stocks. If the 10-year Gsec yield rises to 7% and is accompanied by a 5% weakening in INR/USD, the bank stock index could decline by 12-13%, in our view. Historically, PSU bank stocks and NBFCs (specially housing finance companies) have been more responsive to changes in forex and rates.

Changes in IDFC India portfolio

In line with our theme, we go Underweight (UW) on banks from Equal weight (EW) earlier (reduced SBI); we remain UW NBFCs (including Shriram Transport, research upgrade). We have upgraded Cement to Overweight (OW; ACC, better realization), increased OW on consumers (Asian Paints - demand traction, market leader) and reduced our UW on Power Utilities (NTPC - supported by earnings and cheap valuation).