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India 50 (CFD version of India’s benchmark stock index Nifty 50) plunged to two month low of around 15670.00 during the Indian session of trading Thursday. India’s Nifty 50 index made a low of around 15737.55 against March's low of around 15671.45. In any way, India 50 tumbled almost -7.61% in May (till date) after around -2% slump in April amid the concern of faster Fed and RBI tightening.
India 50 was already under stress on the concern of faster Fed tightening, Chinese zero COVID lockdown, higher imported commodities including oil amid lingering geopolitical tensions and economic sanctions (Russia-Ukraine/NATO), and a subdued report card (Q4FY22) including muted guidance or even guidance warning amid increasingly higher input costs and fragile global economic recovery.
On 4th May, India’s central bank RBI stunned the market with an unexpected and unscheduled rate hike by +0.40% barely 12-hours before Fed’s much-anticipated rate hike (+0.50%). India 50 tumbled over -4% after RBI Governor Das, a known dove, announced +0.40% repo, SDF, MSF and +0.50% CRR rate hikes without any prior indication or forward guidance. But India 50 also recovered from its RBI low after Fed’s less hawkish hike. In any way, Dow Future, as well as India 50 Future, again tumbled on 5th September after the CME Fed Watch tool shows an almost 83% probability of a +0.75% rate hike in June despite Powell’s ‘assurance’ about a +0.50% move. This shows that the market is not taking Powell’s assurance at face value as fine prints of his Wednesday Q&A session do not rule out bigger rate hikes and above +3.00% moves.
India’s RBI tone changed almost 180 degrees in barely 4-weeks just ahead of Fed’s much anticipated +0.50% hike on 4th May. RBI may have thought that Fed will hike another +0.25% on 4th May after a similar hike in March. But the reality is that Fed will not only hike +0.50% in May but may also hike at a similar rate in June and July.
RBI has to follow Fed’s policy action (rate hikes and QT), whatever may be the rhetoric. Although RBI said it does not follow any rule book, in reality, it has to follow the Fed rule book; otherwise, USDINR will appreciate unorderly and there will be unusual outflows. Angel investors will invest in Bidenomics rather than Modinomics, if RBI fails to keep real bond yield differential (FX risk-adjusted) not attractive enough wrt to US yields.
Although RBI tried to paint a deteriorating macroeconomic situation in the last 4-weeks due to lingering Russia-Ukraine/NATO geopolitical tensions and economic sanctions, in reality, nothing has changed drastically in the last 4-weeks since RBI's last scheduled policy meeting on the 8th of April. In April, RBI may have hiked +0.25% in line with Fed’s +0.25% hike in March. But RBI stays on hold and goes for only a backdoor hike in the reverse repo with no firm indication of a hike in June. In the last few months, despite hotter inflation and tighter Fed policies, RBI was quite dovish and continues to ignore its sole mandate; i.e. to maintain 4% price stability (inflation).
In India, RBI usually does not actively jawbone/telegraph the market about any possible policy rate action, unlike its U.S. counterpart Fed. RBI may be the only major global central bank in G20, which goes for any drastic change in policy action without any telegraph or attempt to prepare the market well in advance. Thus the sudden rate hikes by the RBI on 4th May, just ahead of the Fed, spooked the Indian stock market. The market was not prepared for such an unexpected rate hike by +0.40% after RBI’s April MPC meeting barely 4-weeks ago.
RBI may have earlier thought that Fed may hike only by +0.25% in May after March’s +0.25%. RBI may have also planned to match Fed’s anticipated +0.50% rate hikes in March and May by June through a +0.40% rate hike. But Fed’s tone also changed drastically after the 8th April RBI meeting, when Bullard jawboned the market for +0.75% rate hikes.
On 4th May, RBI Governor Das said RBI is now only reversing COVID pandemic era rate cuts. RBI cuts repo rate by -0.75% on 27th March’2020 to +4.40% in an emergency move (off-cycle meeting) after the Indian Government announced an all-out national lockdown for COVID. RBI also cut the reverse repo rate by -0.90% to +4.00% and CRR by -1.00% to +3.00%. Then RBI further cuts the reverse repo rate by -0.25% to+3.75% in Apr’20 in an off-cycle move. After that RBI further cuts the repo rate by -0.40% to +4.00% on 22nd May’2020 amid an ongoing national COVID lockdown. RBI also cuts the reverse repo rate by -0.40% to +3.35%. Before COVID, RBI’s repo rate was +5.15% against reverse repo +4.90%. In Jan’19, the RBI repo rate was +6.50% against the reverse repo rate of +6.25%.
As COVID monetary stimulus, RBI cuts the official reverse repo rate to +3.35% against the repo rate of +4.00% to encourage bank lending. The spread was 65 bps against the pre-COVID normal spread of 25 bps, so banks were discouraged to keep excess cash with RBI for a risk-free relatively higher return. Fast forward RBI effectively hikes the reverse repo rate (through SDF) by +0.40% to +3.75% in the April meeting as 1st strep toward pre-COVID normalization. Then RBI hiked +0.40% repo and reverse repo rate on 4th April. Now repo rate is +4.40% against the reverse repo rate of +4.15%; i.e. at the pre-COVID normal spread of 25 bps. Also, before the April hike in reverse repo rate to +3.75%, the effective market rate of reverse repo was around +3.75% as RBI was absorbing huge system liquidity through VRRR.
Overall, RBI will now tighten in line with Fed not only to control demand and inflation but also to maintain the present bond yield differential (adjusted currency hedge). On 4th May, RBI Governor Das said RBI reversed the +0.40% rate cut which it did on 22nd May’20 (during COVID lockdown). Das also indicated next step may be to reverse the 0.75% rate cut, which it did on 27th March’20. RBI’s next MPC meeting will be on 8th June, before Fed’s 15th June. Powell has clearly said Fed will hike @+0.50% both in June and July. In 2022, till June, Fed will hike by +1.25% (assuming a +0.50% hike in June). Thus to match Fed, RBI may hike +0.75% in June for a cumulative +1.25%. In Aug, RBI may also hike +0.50% against the Fed’s possible hike of +0.50% in July.
Fed Chair Powell has also indicated if core PCE inflation eases on a sustainable basis in the coming months, Fed may hike +0.25% in September, November, and December rather than +0.50%. Assuming that holds Fed will cumulatively hike by +2.50% to reach a neutral rate of +2.75%. Accordingly, RBI may also hike +0.35% in September coupled with +0.25% each in December and February’23 for a cumulative hike of +2.50% (in line with Fed). If Fed goes for +0.50% or even +0.75% rate hikes in September, November, and December, then RBI also has to match Fed.
On Thursday, India 50 tumbled after a report quoting RBI sources indicated RBI may up its inflation projections and may hike rates in the June meeting by +0.75%. Earlier there was another report that the Modi Government has asked RBI to lower bond yield by going for large scale OMO (backdoor QE) or operation twist.
As per RBI source:
· The MPC did an off-cycle hike as it did not want to bunch off a big hike in just two meetings in June and August. They wanted to spread it (out)
· The RBI had said in the past that inflation was on account of supply concerns. The same narrative remains but now the supply side constraints have worsened. Now, RBI is forced to act
· In the next 6-8 months, all central banks including RBI will be "killing whatever demand" there was in the economy in their fight to contain inflation
· The risk of stagflation remains high and the world's most powerful central banks do not have a weapon against it. Let's wish that does not happen
· RBI will help the government to bring down bond yields using various instruments, though the degree of help would not be as much as that in the last two year
· RBI is not targeting any particular levels (of currency) but does not like "jerky" movements of over 0.50 Indian rupees against the dollar in one day
But there was also another ‘source-based news from the Indian bond market that indicated RBI may go for a +0.75% rate hike in August instead of June. In any way, USDINR jumped to a fresh lifetime high of around 77.45. Although higher USDINR will be good for exporters (IT/Tech, Pharma) and almost 50-60% of Nifty earnings now come from exports, it’s negative for the overall Indian economy as imported inflation will soar; India is an import-oriented economy and import almost 85% of its oil requirement.
On Thursday, the Indian market focus was also on inflation data to be released after the market hours. The market was already concerned about hotter inflation, which came true. The Government data shows India’s headline CPI jumped to +7.79% in April (y/y) from +6.95% recorded in March, and higher than the market expectations of +7.50%. The April’22 CPI is the highest in the last 8-years (since May 2014) amid elevated food and fuel inflation. On a sequential (m/m) basis, the headline CPI soared +1.43% in April from +0.96% recorded in March and the highest since Oct’21. India’s core CPI jumped +7.00% in April from +6.40% in March (y/y), much higher than the market expectations of +6.50%.
The unusual surge in sequential CPI since March indicates the adverse effect of elevated transportation fuel and other commodities on the overall Indian economy as a result of the Russia-Ukraine war. Looking ahead, channel check on Main Street suggests that inflation will further soar in May and subsequent months. In India, producers have strong pricing power as there is a wage-inflation spiral, while wage growth is above productivity levels. The April sequential CPI rate of +1.43% suggested annualized rate of around +17%. In May, even if the sequential rate decreases abruptly to +0.50%, the annual rate would be around +6.50%. But in all likelihood, the m/m sequential rate may further rise towards +1.75% or even +2.00% in the coming months amid the lingering Russia-Ukraine conflict.
Although RBI officially follows headline CPI for policy implementation, in reality, it’s now following core CPI. In 2021, the average CPI was around +5.14% against the core CPI of +5.92%. In 2022 (till April), the average CPI is around +6.71% against the core CPI of +6.33%, both substantially over the RBI target of +4.00% and even the upper limit of +6.00%.
In reality, RBI is behind the inflation curve for a long and virtually treating 6.00% of the upper tolerance level as the target instead 4.00%. The Indian economy was already under a stagflation-like scenario (lower economic growth, higher inflation, and higher unemployment) even before COVID. Although RBI never admits it, now it seems that RBI is quite concerned about the stagflation-like scenario because of Russia-Ukraine/NATO geopolitical conflicts, subsequent economic sanctions, and supply chain disruptions. The resultant higher inflation and lower GDP growth may indeed cause stagflation and even an outright recession (after RBI tightening). India’s inflation expectation (1Y) is now hovering around +11.5%, almost double RBI’s upper tolerance band of +6.00%.
Elevated inflation is now a dual issue of higher demand and lower supply. A central bank has only policy tools to control the demand side of the economy (by tightening), not supply (which is controlled by the administration, Lawmakers, and various geopolitical events). A central bank has to bring down elevated inflation by controlling demand so that it matches with the current supply capacity of the economy (balancing act). If a central bank does not control elevated demand/inflation, discretionary consumer spending will be affected at one point amid a higher cost of living, which will itself cause a recession.
Thus RBI also has to control inflation by slowing down the economy/demand through calibrated tightening without causing an outright recession. So far, RBI was unwilling to slow the economy and control inflation as the entire focus was on growth. RBI believes there is sufficient spare capacity in the economy and thus ultra-accommodative monetary policy (by Indian standard) is required.
But RBI is now shifting its focus/priority to price stability from growth as uncontrolled inflation will cause lower discretionary (non-essential) consumer spending and eventually result in lower GDP growth. Normally, like all other major central banks, RBI also follows Fed’s actual or even prospective policy action to maintain the real bond yield differential attractive enough, so that angel investors continue to invest in Modinomics (India growth story). But this time, despite Fed hiking +0.25% in March, RBI is on hold in April because the real rate of interest is much lower in the U.S. than in India. But now with faster Fed tightening and surging Indian inflation, the difference between the real rates of interest is decreasing and thus RBI has to act.
As per Taylor’s rule, for India:
Recommended policy rate (I) = A+B+(C+D)*(E-B) =0+4+ (1.5+0)*(6-4) =0+4+1.5*2=0+4+3=7%
Here for RBI:
A=desired real interest rate=0; B= inflation target =4; C= permissible factor from deviation of inflation target=1.5 (6/4); D= permissible factor from deviation of output target from potential=0; E= average core CPI=6
As per Taylor’s rule, which Fed policymakers generally follow, assuming India’s ideal real interest at 0%, the RBI repo/policy/interest rate should be +7.00% against the present +4.40%. Thus RBI may hike to 6.5% by FY23, depending upon the actual trajectory of inflation, which may surge well above +8.00% or even +10% double digits in the coming days amid higher costs of transportation fuel, and food as-well-as core inflation, which may also surge well over +8%.
India is already paying around 45% of its core revenue as interest on a public debt against America’s 9%, Japan’s 15%, and China’s 5.5%. Thus India can’t afford too high a bond yield and has to control inflation. RBI has to be ahead of the inflation curve by faster tightening; otherwise, RBI's credibility may be at stake.
India’s 10Y bond yield was already hovering above +7.00% since early April amid elevated inflation (as March CPI almost scaled +7.0%) and as RBI hiked SDF/effective reverse repo rate. Now, the 10Y bond yield is hovering around +7.25% against US’ +2.83%. Higher bond yield; i.e. higher borrowing cost is negative for the equity market, especially for interest-sensitive sectors. Although higher bond yield is positive for a bank’s lending model and higher NIM, the demand for the loan at higher borrowing costs will be lower. For most Indian PSU banks, higher bond yield; i.e. lower bond rates will be negative for their MTM bond portfolio. Almost 50% of the EBITDA of PSU banks comes from this bond portfolio.
The Fed's tightening pace will depend on the U.S. inflation trajectory. The U.S. inflation will now largely depend upon the trajectory of the Russia-NATO proxy war over Ukraine and subsequent economic sanctions. Russian President Putin is now in no mood to exit from Ukraine without any major success, because of domestic political compulsion.
On the other side, U.S. President Biden is now trying to linger the proxy war against Russia by an unlimited supply of military equipment and financial assistance to Ukraine. The war of attrition between Russia-Ukraine/NATO maybe now equivalent to WW III, which may linger to Nov’22 U.S. mid-term election or even the Nov’24 U.S. Presidential election. The real WW III may not happen because of the fear of an all-out nuclear war between Russia/China-NATO.
Biden is now trying to recapitalize his falling approval rate through the proxy war against Russia and shifting the blame of ‘Bidenflation’ to ‘Putinflation’, which is now expected to be elevated till at least late 2022 or even late 2024. Biden may try to control domestic inflation by withdrawing Trump tariffs on Chinese goods (as a tax cut to hard-working ordinary Americans ahead of the mid-term election).
But China’s zero COVID lockdown policy and subsequent supply chain disruptions along with Russia-Ukraine-related lingering supply disruptions of key commodities will cause sticky fuel and food inflation in the coming days. Thus Fed may be compelled to hike @+0.50% even in September, November, and December to reach a +3.50% neutral (?) rate by Dec’22 (as suggested by St’ Louis Fed President Bullard).
Fed’s Chair Powell almost assured the market about +0.50% rate hikes in June and July. Powell also indicated rate hikes @+0.25% in September, November, and December, providing a sequential reading of core PCE inflation eases as per Fed’s expectations. But Powell also kept open about the higher quantum of rate hikes in September, November, and December if inflation does not ease or even accelerate. Thus Fed may also hike @+0.50% in September, November and December to reach +3.50% by Dec’22, in line with Bullard’s suggestion. And Fed may also front-load a +0.75% rate hike in September, followed by +0.50% each in November and December to reach Bullard’s latest estimate of a neutral rate of +3.75% by Dec’22.
RBI may also hike in line with Fed cumulatively by+2.50% at least to reach a +6.50% repo rate by Feb’23. And RBI has to improve its communication/thought process in line with practices of major global central banks/Fed to avoid such knee-jerk reactions to the market. Although the Indian bond market may have already anticipated RBI tightening, the equity market was stunned. As the financial market always works with future expectations, RBI has to prepare the market well in advance rather than keeping a ‘secretive’ stance (like in old days). If Fed indeed hikes to +3.50% or +3.75% cumulatively by Dec’22, RBI also has to follow irrespective of any narrative; otherwise, USDINR may soar towards 100 levels and imported inflation will further jump.
Despite higher inflation, India has stable macros and very low external debt. Being a vibrant democracy and a big country, India also enjoys a scarcity premium among its EM peers (except China) amid political and policy stability. This coupled with the attraction of Modinomics and 5D (democracy, demand, demography, deregulation, and digitalization), India is now a favorite destination for FDIs and FPIs. Thus any unusual volatility may be also an opportunity in adversity to enter the Indian market.
Looking ahead, whatever may be the narrative, technically India 50 now has to sustain over 15600 levels; otherwise, 15400-350 may come and sustain below that India 50 may further fall to 15000/14850-14400/13900 and even 13675/13050-12190/11670 in the coming days. On the positive side, sustaining above 15600, India 50 may rally to 16000/16200-16600/16925 and further 17250/17450-17625/18230 levels in the coming days.
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