In nature and in economics, there is a natural inclination to move towards equilibrium or reach a state of balance. Consider the simple act of throwing a stone into a pond, disrupting its calm surface. The resulting ripples and waves spread outward, affecting the entire pond until they eventually fade away, returning the water to its original peaceful state.
Likewise, in economics, equilibrium refers to a state where the forces of supply and demand are in balance. However, external factors such as changing consumer preferences, technological advancements, fluctuating input prices, and government policies can upset this balance. When such disruptions occur, market forces step in and adjust prices, working to restore equilibrium.
The recent alterations in taxation policies for mutual funds and insurance have disrupted the equilibrium in asset allocation between fixed income and equities. This disturbance caused by increased taxation and the removal of indexation benefits on debt instruments held for more than three years have resulted in reduced post-tax expected returns for fixed-income mutual funds and insurance products. But the post-tax expected returns on equities have remained unchanged. As a consequence, equity as an asset class has gained relative attractiveness for asset allocators, making investors increase allocations to equities over fixed income.
This shift in investor preferences will set in motion a series of market dynamics. As more investors flock to equities, their prices will gradually ascend. Bond prices, however, will experience downward pressure i.e. yields will rise. This trend will continue until the post-tax returns on equities are no longer perceived as attractive, forcing a rebalance.
However, the bond markets are currently rallying- particularly the 10-year and above maturity segment. This rally can be attributed to the substantial inflow of money from investors seeking fixed-income options.
Given the growth-inflation dynamics and the unfavourable post tax return on fixed income, as the current phase of inflow deployment comes to an end, we believe the demand will subside in the times ahead. Therefore, investors should be cautious of taking high duration risk at this point of time.
Also, the common thought in the market is that interest rates have peaked and the Reserve Bank of India (RBI) will start cutting interest rates soon.The argument for interest rate cuts arises from the assessment of the economy during the 2014-2020 period, characterized by sluggish economic growth and declining bond yields. In the initial part of this period, the RBI aimed to cool down an overheated economy, grappling with late-cycle macroeconomic challenges. However, the subsequent adoption of a 4 per cent inflation target has led to overly tight financial conditions. Moreover, the incomplete clean-up of the financial system left many banks undercapitalised, resulting in higher borrowing costs and a slowdown in credit growth.
However, the current conditions differ significantly from those of the 2014-2020 period.
The financial system's balance sheets have undergone clean-up and are now well capitalized. Banks and non-banking financial companies (NBFCs) are actively competing for credit growth, absorbing some of the impacts of interest rate hikes and transmitting monetary policy tightening only partially to the borrowers. Additionally, the RBI has shifted its approach away from a strict point target for inflation.
Over the past three years, the average realised inflation has exceeded 6 per cent, while the current repo rate stands at 6.5 per cent, indicating that the real interest rate is not restrictive. Overall, these factors suggest that financial conditions are much more accommodative compared to the 2017-2018 period, even at similar repo rate levels.
Central banks play a crucial role in adjusting monetary policies in line with the ever-changing business cycles of economies. These policies can range from accommodative to neutral to tight, depending on the assessment of the current phase of the business cycle. Currently, the United States is experiencing a late-cycle phenomenon, leading the Federal Reserve to adopt a tight monetary policy stance. In contrast, the Reserve Bank of India (RBI) is gradually moving towards a neutral stance as the Indian economy finds itself in the mid-cycle phase.
In contrast to the prevailing belief in the market that interest rates in India have reached a terminal point, the RBI is clearly communicating its intention of taking its stance closer to neutral. In a neutral stance, interest rates are typically kept stable, unless changes in the business cycle necessitate a shift towards accommodative or tighter policies. In the mid cycle, RBI's objective is evenly balanced between supporting economic growth and closely monitoring inflationary pressures and external factors.
For a long time, the Indian economy has failed to expand in the mid cycle. Private sector investments, too, have not grown as expected. But after a long time, domestic macroeconomic conditions such as supportive government fiscal policy (especially in infrastructure investments), stable current account, and a deleveraged corporate sector are playing out. We just need animal spirits. To conclude, the growth-inflation dynamics currently does not point to growth slowing down. The room for a rate cut is very limited. Also, the flows into fixed income are likely to slowdown in the months ahead. Due to these factors, we believe the yield in the medium term will go up. Hence, there is a risk in the higher duration segment. Investor seeking to invest in fixed income can consider short duration schemes or dynamic duration schemes which can dynamically manage duration to handle interest rate volatility to navigate any market condition.
Manish Banthia is Deputy CIO-Fixed Income, ICICI Prudential Mutual Fund.
Views are personal, and do not represent the stand of this publication.
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