A Triple Test Awaits the Market

With three major risk events lined up in the near future, we outline our expectations on these and our outlook for FX, Bonds, and Equities.

The Fed Policy 

(26th Jan 2022)

With the output gap still negative, consumption weak, labor force participation low, we expect the Fed to push back a bit on the tightening expectations the market is currently pricing in. This view differs from the consensus view. We believe that merely through its hawkish communication the Fed has succeeded in driving long-term inflation expectations lower. 5y5y breakevens which were at 2.30% a few sessions ago are now down to 2.07%. The Fed would want to anchor long-term inflation expectations close to 2% but would not want it to dip much below 2% as it would adversely impact growth.

We expect the Fed to tighten in a phased, calibrated manner. The lift-off may1 begin in March but we believe four hikes in 2022 is not a given. The number of hikes would depend on how the economy reacts to the tightening.  

The Union Budget

(1st Feb 2022)

With the economy still on the mend from the pandemic shock, it will be interesting to see how the FM strikes a balance between fiscal consolidation and continuing spending that can stimulate growth.

The FM will need to prioritize and therefore we expect the budget to target specific sectors. We expect the key themes of the budget to be rural India, MSMEs, and the service sector as these have been the worst affected by the pandemic. Infrastructure, export-oriented manufacturing, and labor-intensive industries are likely to catch the FM's attention. 

Bond markets are likely to focus on the fiscal deficit number for FY'23 (exp 5.8%) and the gross borrowing number which we expect to be close to Rs 12.5 lakh CRS. Bond markets are also closely looking forward to any announcement pertaining to the inclusion of domestic bonds in a global bond index. 

Equity markets would like to see the focus on spending which can have a multiplier effect across the value chain i.e. with strong forward and backward linkages. Focus on infrastructure, logistics & supply chain, and housing would be received well.

RBI Monetary Policy

(9th Feb 2022)

We expect the RBI policy stance to continue to remain accommodative and growth supportive. There is a possibility we may see the Reverse repo being hiked by 20bps. We do not expect that to have a disruptive impact on Rates and Bonds. Stealth tightening through more durable liquidity absorption has already seen overnight rates move closer to the repo. 

If index inclusion happens, we may see the RBI sell bonds and Buy Dollars. If index inclusion does not happen we may see the RBI resort to a twist i.e. selling short-term bonds and buying long-term bonds to cap long-term government bond yields. Both of these would ensure that no net liquidity is injected into the banking system.

We expect forwards to remain volatile heading into financial year-end with several IPOs lined up, Rupee liquidity gradually tightening, and possible LEF-related paying by foreign banks. If the carry remains elevated, we may see upside in the USD/INR spot remains capped. We continue to see USD/INR trade a 73.80-75.30 range over the medium term. 

The RBI policy is likely to be influenced by the Fed policy and the Union Budget. 

Besides the above three risk events we are closely following:

1. Crude Prices: Crude prices are hovering close to seven-year highs. If crude prices break higher and sustain at higher levels, it alters India's BoP math and macroeconomic outlook significantly.
2. Geopolitical developments around Ukraine: The tensions between US and Russia have been escalating and the situation continues to remain tense. 
3. USD/CNY: There is a risk of a downside break on USD/CNY. RBI may become permissive of Rupee strength if the Yuan strengthens.