“I see your light shining in through the night“
Zoe, Sunshine on a Rainy Day
Last week, we discussed the most recent monetary policy decisions from the ECB, Federal Reserve, and the Bank of England, in each instance suggesting that, in our opinion, the respective central banks have likely completed their hiking cycles. In each case, however, the transmission of the current (restrictive) monetary policy settings to the real economy will be a function of the both the level and duration of policy restrictiveness. In that regard, and against the uncertainties of the interaction between the effects of policy tightness on the global (and domestic) demand profile and the improving supply backdrop, all three central banks are data dependent.
From our perspective, this is a very important part of the cycle. If we put the UK to one side for a moment where the growth inflation backdrop is perhaps most distorted (weak labour force dynamics but high fiscal and rapidly weakening growth dynamics), the recent central bank rhetoric has been starkly divergent and the impact on the currency space notable. Essentially the ECB, having raised rates while lowering their growth projections throughout the forecast horizon, gave a clear signal that unless the data were to prove them wrong to the downside, that their hiking cycle is complete and that their main policy focus going forward is predominantly the duration over which policy will be held in restrictive territory in order to get inflation back to target (“as fast as possible” – a recent official addition to the policy rhetoric).
In the US, however, the emphasis was the opposite, growth projections were raised (while inflation projections lowered), giving a clear signal that if the data were to prove them wrong to the upside, then they would continue their hiking cycle (one additional hike this year) and would leave rates at the more restrictive setting for longer (fewer projected rate cuts in 2024).
Despite these alternate emphases, the growth projections of the ECB and the Fed are remarkably similar (even if the descriptive narrative of the Fed has shaped the perceived risks to be in the opposite directions for Europe and the US). Inflation projections are lower in the US – but the implied policy urgency is greater in the US!
In our view, the upcoming data, most significantly the next two inflation and employment report prints are critical to the market emphasis on a positive growth (and thus rate) divergence in favour of the US – and thus also of US / Europe rate differentials and EURUSD. Market positioning and analyst sentiment seem to think that this is clear. We are less convinced.
Outside of the core markets this week, there has been an interesting announcement regarding India’s inclusion in global bond indices. We have some initial thoughts.
With a lead time of nine months, India will enter into the JPMorgan GBI-EM bond index from the end of June 2024, with the weight increasing one percent per month to reach the index ceiling of ten percent by the end of March 2025. This is a hugely significant development, not just for the integration of India into the global financial system, or a recognition of the size of the Indian capital market and global economic clout, but also in terms of flows. Flows into index tracking portfolios will ultimately be around twenty-five billion dollars.
At the current juncture, the repricing of the term premium in the US yield curve is something that is front and centre of global financial markets, for reasons that we have discussed at length over recent weeks. However, while there is significant volatility in global bond markets led by the US curve, the case for India is a compelling one.
Of course, the prospective flow dynamics of inward investment are compelling in their own right, but there are also a number of macro factors supportive of owning Indian bonds. Firstly, after a sharp policy normalisation from the Covid accommodation of 3.50%, the RBI has tightened the policy rate to 6.50%; and now, secondly, despite the recent inflation spike (driven to a significant degree by anomalous weather on rice and vegetable crop yields), which has already started to moderate, the monetary policy bias in India is neutral in the very short term - and dovish beyond that. Thirdly, despite the fact that we are approaching a general election in India (April - May 2024) and that fiscal giveaways in the run-up to elections are commonplace, the government is committed to cutting the fiscal deficit.
Essentially, fiscal consolidation continues, inflation is coming down as growth stabilises, and the monetary impulse turns dovish. Against this macro backdrop, a very strong case for owning Indian bonds can be made. Of course, there are election risks, and the currency remains under pressure, as the RBI rebuilds its global reserves; but the case remains strong to own Indian bonds, from our perspective.
As far as the global backdrop is concerned, and to paraphrase Zoe, India is something of a ray of sunshine on a rainy day. However, we continue to believe that the US curve uncertainty is a passing shower, and that slower growth alongside a further inflation slowdown in the US, will generate a significantly less risk averse backdrop. For that, however, we need to see the data.
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