CBR Review - Softer Action, Harsher Guidance

Surprisingly for the market, the CBR raised rates by only 25 bps today. However, the accompanying press release sounded more hawkish than in July, in our view. By doing so, the CBR signaled its intention to return to a more gradual adjustment of monetary policy. This approach can be attributed to the high uncertainty about the macro conditions and having already delivered substantial tightening this year. On the other hand, it signaled that the hiking cycle is to continue without any pre-determined ceiling. In light of this, we expect the CBR to continue hiking in 25 bp increments until the run rates of inflation return to 4% in annualized seasonally adjusted terms. That is unlikely to happen at least until the beginning of 2022, which means that hikes in October and December are quite likely. Our key rate projections for 2021 and 2022 remain intact at 7.25% and 6.00%, respectively. Inflationary backdrop still has not improvedThe CBR highlighted that inflation continues exceed its projection, with the August print spiking back after a temporary slowdown in July. Notably, the regulator did not revise its latest year-end inflation forecast of 5.7-6.2%, as today's meeting was a non-core one. However, the inflation forecast was not mentioned in the press release either, which might mean that there is a high probability of a forecast revision at October's meeting. Similarly to previous meetings, the CBR flagged that sustainable inflation components remain significantly above 4%, which suggests that demand keeps outstripping supply in a number of economic sectors. In terms of risks, the CBR noted that they are still skewed towards pro-inflationary, which is amplified by high inflation expectations. Economy set to return to balanced growthIn its press release and during the press conference, Governor Elvira Nabiullina stressed that the Russian economy has reached the pre-pandemic level and is returning to a balanced growth trajectory. Growth in real wages and a lower than usual saving ratio (due to increased inflationary expectations) support consumer spending, especially for non-food goods. The remaining disbalance between the fast expansion of domestic demand compared with limited possibilities to expand the production and to increase the supply continues to create pro-inflationary pressure in a wide range of industries, as it is easier for companies to transfer increased costs to prices (including higher commodity prices in global markets). Another important factor is the improved situation in the labor market, where unemployment has almost declined to pre-pandemic levels, while vacancies are at historic highs. There is strong and growing demand for labor across a wide range of industries, which coincides with a deficit in some sectors (also due to remaining restrictions on the inflow of migrants). The situation in the labor market shows that higher sustainable growth rates of the Russian economy could be achieved primarily by an increase in labor productivity. As a result, the regulator estimates that with government structural measures, the economy's sustainable growth rate could be at 2-3% in the next few years, slightly slowing down compared with the recovery phase of the economy.The CBR expects inflation to decelerate in 4Q21, as temporary factors should begin to fade away while the tightening of monetary policy, which started in March, should already begin to affect inflation.Forward guidance became more hawkish, but less certainThe main policy signal shifted from "the bank will assess the necessity of further rate hikes" to "the bank does not rule out additional rate hikes" at upcoming meetings. At the press conference, Nabiullina acknowledged the tone of the wording has become more hawkish and placed special emphasis on the high uncertainty related to the current economic conditions and effects of the tightening already delivered. For that reason, a 25 bp policy step could again be a more preferable one, according to Nabiullina, but there might be several additional hikes needed in the current policy cycle. She did not rule out that the key rate could end up above 7% in the coming months, while also saying that it was premature to discuss the timing of the potential reversal to monetary easing. On a separate note, the governor mentioned that the CBR had considered three options for this decision: no change in rates and 25 bps and 50 bps rate increases. CBR's decision and rhetoric not game-changingThe meeting has not changed our baseline view on the endpoint for the current rate hike cycle. We expect the regulator to keep raising rates until inflation normalizes. Our macro team estimates that this will happen no earlier than the beginning of 2022, so similar rate hikes in October and December look highly likely. As such, we still expect the key rate to reach 7.25% this year. Our projection for next year also remains unchanged: we think the bank will start easing policy in 2Q22 and bring the key rate down to 6% by the year-end. That said, today's softer than expected hike slightly increases the probability that the rate-cutting cycle could be delayed next year, since it might take longer for inflation to normalize. The local swap market has taken the CBR's decision as a sign that the peak of the hiking cycle might be lower than previously expected: 6m-2y OIS rates dropped 8-12 bps in the wake of the decision, while 1y-2y IRS eased 3-5 bps. We doubt that this is a correct move, given the more hawkish tone of the CBR's statements. That said, the corresponding forwards were slightly above our expectations, so we would not advise fading the move. The prevailing market pricing still suggests a year-end key rate of around 7.25%, which we consider fair. There are subtle, reassuring signs in the data that cause us to think that level may be the terminal point of the cycle. In particular, prices for construction materials have been declining for the past two weeks, retail loan growth has started to ebb, household and business inflation expectations declined in August (albeit they remain elevated), and the economic recovery continued in 3Q21, but at a slower pace. However, with the risks still heavily skewed to higher short-term rates, we still think it is worth being exposed to further flattening of the OFZ curve and deeper inversion of swap curves. In OFZs, we still like the "new" OFZs maturing in July 2031 (target yield 6.80%, current yield 7.14%). The fact that the CBR has been proactive in tightening this year should help return inflation to the target next year and keep inflation risk premiums at bay. As we have mentioned before, the issue is currently one of the most liquid "new" OFZs, with around R280 bln outstanding, and it is one of the issues that looks most likely to reach its size limit of R500 bln (along with the 8y OFZ 26237, which currently has R214 bln outstanding). Due to the ongoing rapid increase in the size of the issue, we think it is likely to start gradually attracting more interest from accounts that are more averse to compliance risks, as the new OFZs effectively become identical to the old ones once the Finance Ministry has finished tapping them in the primary market (see our note). On top of that, primary market conditions have turned more supportive recently: the residual borrowing needs for this year are looking modest, and the Finance Ministry could switch back to limited auctions in the coming weeks. Also, the CBR has recently continued talking about a potential downward revision to the inflation target. In particular, one interesting idea might be to buy the aforementioned OFZs versus paying short-term FX swaps, which could see additional upward pressure from a rapid improvement in onshore FX liquidity. The latter will be supported by increased activity of Russian issuers in the primary market in September (see our latest FICC Bi-Weekly) and the large current account surplus, which reached a multi-year high of $18 bln in August. Meanwhile, the CBR estimates that net external debt payments by nonfinancial organizations in 3Q21 will total $7.8 bln (adjusted for intragroup financing), which is 15% lower than last year.