The widely anticipated rate cut bonanza has been put on ice. Contrary to expectations of sharp rate cuts at the beginning of this year, market watchers now seem resigned to a delayed and shallower softening. This has implications for investments in the bond markets.
Get ready for ‘higher for longer’
The US Federal Reserve poured cold water on investors’ rate cut hopes in its recent monetary policy review. In a clear shift of tone, Fed Chairman Jerome Powell suggested that interest rates need to remain restrictive for a longer period. Stickier inflation is the main culprit behind the Fed’s watchful stance. Continued strength in the US employment numbers, suggesting a humming local economy, further keeps the central bank’s hands tied. The Fed typically cuts rates only when the economy is weakening and needs help. It does not want to cut rates too soon, a mistake past policymakers made. “It is now evident that the Fed’s ability to act on rate cuts is contingent on a more benign inflation outlook. This scenario supports the ‘higher for longer’ narrative, naturally leading to higher yields,” asserts Vikas Gupta, CEO and Chief Investment Strategist, OmniScience Capital. The market now expects two rate cuts by the Fed in 2024—down from four previously—and a shallower easing cycle with a cumulative 175 basis points (100 bps is 1%) of easing (against 300 bps previously) through 2025.Bond yields have started moving up again
Hawkish US Fed signals, crude oil price spike and inflation concerns have kept bond prices muted.
A delay by the US Fed in reducing rates is likely to weigh on the RBI’s decision on starting its own policy rate easing cycle. “We have long maintained that the RBI’s current policy has been somewhat pegged to the Fed, even as it formally targets domestic inflation. The RBI will not precede the Fed in any policy reversal in 2024, but policy management will have to stay vigilant amid the fluidity of global narratives,” insists Madhavi Arora, Lead Economist, Emkay Global Financal Services.Apart from the global central bank actions, the RBI is also keeping a close eye on crude oil prices and the progress of the monsoon. In its latest policy review, the central bank maintained its mildly hawkish tone, emphasising the challenge posed by food prices in achieving the final stage of disinflation and reaching its 4% target. Additionally, the central bank reiterated the importance of an actively disinflationary policy and reaffirmed its determination to align inflation with the target on a durable basis. This should keep rate cuts on the backburner for some time. Pranay Sinha, Senior Fund Manager, Fixed Income Investments, Nippon India Mutual Fund, asserts, “The direction of rate movement is more predictable at this juncture; it is the timing of the rate cut that is uncertain. Any change of timing of rate cut from Fed and a deviation from their dot plot can cause delay in rate cut by the RBI.”In fact, some even expect rate cuts to be pushed further to 2025. Analysts at Morgan Stanley expect no easing in domestic policy rates in 2024-25. “We believe that improving productivity growth, rising investment rate, and inflation tracking above the target of 4%, alongside a higher terminal Fed funds rate, warrant higher real rates,” said Morgan Stanley economists Upasana Chachra and Bani Gambhir, in a note recently. In fact, there has been talk about the potential for a rate hike if inflation doesn’t ease further.How the US rates cycle moved in the past
At nine months, this is now the second longest hold from interest rate peak to interest rate cut.
Note:The cumulative rate hikes at 525 bps since March 2022 have also been above the historical average. Historically, the Fed has kept rates at the peak of the cycle for a maximum of 12 months, after which it started cutting rates. This was before the 2008 global financial crisis.
The impact of higher rates on the economy is severe, but it flows with a lag. On an average, there is a 16-month lag between last interest rate hike and a recession. There have been instances of this period getting stretched to 19 months also. Source: DSP MF
Gearing up for uncertainty
Surprisingly, the resetting of rate cut expectations has not unnerved investors and fund managers. Bond markets have taken the news with nothing more than a raised eyebrow, though some are now ringing the alarm bells. In a blog, Stephen Dover, Head of Franklin Templeton Institute, expressed concerns about investor complacency to monetary policy risk in 2024, as suggested by the relaxed reception so far to a Fed policy of ‘higher for longer’. “If inflation picks up in the face of sturdy US economic activity and a sub-4% US unemployment rate, equity and bond markets could be in for nasty surprises,” he writes. Veteran banker Uday Kotak of Kotak Mahindra Bank has also warned of possible turmoil ahead. “The US inflation is higher than expected. The Fed will postpone rate cuts to later, closer to the presidential elections, if at all. Brent oil is now $90 a barrel. It will keep rates higher for longer worldwide, including India. The only wild card is China’s implosion economically. Get ready for global turbulence,” Kotak posted on X (formerly Twitter).
Many dynamic bond funds are betting on long-term bonds
Fund managers expect rates to be cut soon and are following a longer duration strategy.
Could policymakers make a U-turn and raise interest rates further? Experts maintain that is unlikely to happen. “We continue to believe that the global monetary tightening cycle has effectively ended and the bar for further rate hike in US remains pretty high despite the hawkish posturing by some FOMC members,” remarks Puneet Pal, Head, Fixed Income, PGIM India Mutual Fund.
Rate cut uncertainty has hit funds with duration strategy
Higher volatility in the bond market will keep a lid on returns till there is clarity on interest rates.
Meanwhile, most analysts and fund managers are still convinced that rate cuts are around the corner. “Overall, the macroeconomic environment is turning favourable for a rate cut in mid-2024, under our base case, lest weather and crude prices play spoilsport,” says Dharmakirti Joshi, Chief Economist, CRISIL. Pal reckons there is a fair probability of rate cuts in the second half of 2024-25. “We continue to think that there is scope for rate cuts in India on account of the high real positive rates and the need to encourage private investment. But any rate cut in India will follow rate cuts in advanced economies, and not precede them,” he says. Mahendra Jajoo, Head, Fixed Income, Mirae Asset Global Investments, echoes the optimism. “Even though the market is very volatile and the mood swing is very dramatic, the core approach to a gradual easing of rates from their recent high is still valid. I expect the Fed to cut rates in July-August,” he says.
However, there is a growing acknowledgment that the rate cut cycle could be shallower than initially anticipated. Arora of Emkay remarks, “We were never in the massive rate cut camp and have been arguing against the noises of peakflation and rate cuts since 2022. The world is now converging to our view of a case of ‘no Fed cuts’ in 2024, as they struggle to get to the last mile of disinflation.” Jajoo of Mirae Asset Global Investments reckons, “The rate cut cycle in India is likely to be shallow as the policy rate gap with the US is very narrow, providing limited room for the RBI to cut rates.”
What investors should do
At the beginning of the year, expectations of rate cuts posed a significant opportunity for bond markets, favouring a shift towards duration strategy in debt funds. This was a shift towards longer tenure bonds, which gain the most when interest rates are falling. Bond prices and interest rates move in opposite directions. However, the resetting of expectations could spoil the party for bond investors, at least for the time being. Some experts suggest taking a cautious approach for now.
Fading expectations of early rate cuts by the RBI could upset the G-Sec trade, warns Arora. “Amid still-inverted yield curve, sticky inflation levels ahead and possible volatility, duration on the curve may not be the best place to take risks,” she remarks. Pal of PGIM India Mutual Fund suggests taking the middle path amid the current uncertainty. “Investors with a medium- to long-term investment horizon can consider funds having an average duration of 5-6 years with predominant sovereign holdings as they offer a better risk-reward.” Intermediate duration funds are at a sweet spot for investors in the current scenario, feels Sinha of Nippon India Mutual Fund. These include banking and PSU debt funds, corporate bond funds and short-term debt funds. “The intermediate fund has adequate duration risk, which will benefit investors when rates go lower. However, it has enough discipline in its duration management to protect the investors from volatility and negative surprise from policymakers,” he says.
Most fund managers are adamant that duration is the best play going forward. This is also reflected in the extremely long maturity profiles of several dynamic bond funds. These funds switch between short and long maturity bonds according to expectations in rate changes. Funds like Bandhan Dynamic Bond, DSP Dynamic Bond and SBI Dynamic Bond, among others, are running a very aggressive duration strategy in their portfolios, with a heavy tilt towards longer tenure government securities (see graphic). Suyash Choudhary, Head, Fixed Income, Bandhan AMC, clarifies, “We remain focused on 30-year government bonds in our active duration bond and gilt funds (>90% exposure).”
Pankaj Pathak, Senior Fund Manager, Fixed Income, Quantum AMC, remarks, “We expect bond yields to decline over the coming months. With higher starting yield and possibility of decline in bond yields over medium term, the return potential of fixed-income funds investing in long-duration bonds looks good.” He suggests that investors with 2-3 years holding period can consider dynamic bond funds for the fixed-income allocation in their portfolios.
Less than expected rate cuts would mean tepid returns from long-duration funds
During declining interest rate phases, long-duration funds have significantly outperformed fixed deposits and short-duration funds.
Note:The graphic shows the potential returns for HDFC Long Duration Debt Fund in various scenarios. The net yield to maturity (YTM) is calculated as YTM of 7.2% minus the expense ratio of 0.6%. Price change due to interest rate change is calculated using modified duration as of 31 Mar 2024, assuming rate change happens at the fag end of the year. Source:FundsIndia
Dynamic bond funds have the flexibility to change the portfolio positioning as per the evolving market conditions. This potentially makes these funds better equipped to tackle a volatile macro environment. However, the track record of most dynamic bond funds shows that while these funds flex their muscles in a falling interest rate environment, they often get caught on the wrong foot when rates start hardening.