Short analysis on the US Fed rate cut

-     The US Fed FOMC, yesterday, announced its federal fund (policy) rate wherein the committee decided to reduce the federal fund rate by 25 bps which is the “third rate cut” in 2019. Federal fund rate now stands in the range of 1.5% to 1.75%. The rate cut decision was based on 8-2 votes in favor of the rate cut.          

-          Rationale for the decision:

o   Labor market remains strong and the economic activity has been rising at a moderate pace (GDP for Q3-2019 came in at 1.9%)

o   Job gains have been solid while unemployment rate has been low

o   Household spending has been driving the overall GDP growth while on the other hand business fixed investments and exports remain weak.

o   Both CPI and core CPI remained below 2%; Longer term inflation expectations are little changed

-          Future outlook on US interest rates:

o   Further rate cut actions will be assessed based on incoming information for the economic outlook, keeping the objective of maximum employment and 2% inflation target in mind.

-          How have interest rate changes been over the past few years

                                               US Federal Fund rates (Mid-point plotted)

o   During 2018, the US Fed raised rates by almost 1% as retail inflation remained at around 2.5% for majority of 2018. US unemployment during 2018 remained between 3.5-4.

o   In 2019, the US Fed has declined rates by 75 bps supported by domestic growth concerns. US GDP growth has declined from 3.1% in Q1-2019 to 1.9% in Q3-2019.

§  It is also important to note that US retail inflation during this period has remained below or equal to 2% during 2019 which has extended confidence in the members of FOMC to cut rates in order to support the growth concerns.

-          How do US GDP numbers depict the strength in the US economy?

o   The US Fed FOMC has pointed out that the strength in the US economy gas been driven by personal consumption expenditure while the weakness in gross private investment and exports remains. This can be validated in the following table.

	Q2-2018	Q3-2018	Q1-2019	Q2-2019	Q3-2019
GDP	3.5	2.9	3.1	2.0	1.9
Personal Cons Exp	4.0	3.5	1.1	4.6	2.9
Gross private domestic investment	-1.8	13.7	6.2	-6.3	-1.5
Exports	5.8	-6.2	4.1	-5.7	0.7
Imports	0.3	8.6	-1.5	0	1.2
Govt CE and investment	2.6	2.1	2.9	4.8	2.0

-          Common Thread between US and India Monetary Policy:

	2018	2019
RBI	Increase in rates by 50 bps	Decrease in rates by 135 bps
US Fed	Increase in rates by 100 bps	Decrease in rates by 75 bps

o   The RBI had increase policy rates by 50 bps in 2018 highlighting inflation concerns. On the other hand US Fed increased policy rates by 1% in 2018 highlighting the same reasons.

o   The RBI has been slashing policy rates since February 2018 aggregating 135 bps citing benign inflation and pressing on the importance of reinvigorating aggregate demand.

o   However, there is a slight difference in the commentary between the two central banks. US Fed has stated that the economy is growing at a moderate pace and hence further rate cuts will be data driven. While in case of India, the pick-up in overall growth remains a concern and the MPC will continue with an accommodative stance as long as it is necessary to revive growth.

  

-          Impact on markets:

o   The US equity markets have reacted positively. Dow (0.43%), S&P 500 (0.33%) and NASDAQ (0.33%) ended in the green yesterday. But not to forget the gains were also supported by better than expected corporate earnings.

o   As a natural reaction, US dollar weakened against major currencies owing to lower demand for the US dollar. Also the US yields declined yesterday by 7 bps. However, the fall could have been limited as the Fed commentary states that future course of action would be data driven, indicating that the future course of rate cut action is not given.

o   The gains in the local US equity markets since the partial trade agreement between US and China had led to rise in US yields. The markets were expecting  a rate cut action by the US Fed but despite that the yields have risen from 1.74% (on 16^th October) to 1.84% (on 29 October).

o   How have Indian markets reacted?

§  The markets have risen by around 3.8% since 16^th October. Yesterday the Sensex rose by 0.55%. Sensex continues to remain above 40,000 at present, rising by more than 250 points (till 11:30 am)

§  This has been primarily on account of higher FPI inflows. Higher FPI inflows have aided in strengthening of the Rupee against the US dollar.

§  10 year benchmark GSec yields too declined on Wednesday to 6.49%.

Did you just (F)uck (M)y (P)lans?

The financial market seems to have been entangled in Spiderman’s web. Just as the banks were slowly recovering from the set-back of non-performing assets, the default in payment obligations by Infrastructure Leasing & Financial Services (IL&FS) on term deposits (including short term) caught headlines. This failure had severe consequences, especially for the non-banking financial services (NBFCs) sector as the yields on their short and long term borrowings saw an uptick. No sooner had things in this space moderated, a new crisis has engulfed the financial market. On this occasion, however, the faithful investors who have a strong belief in the technical expertise of fund managers, investing their hard-earned money into a product named “fixed maturity plans” (FMPs) have been caught in a spot of bother.

What is this new crisis?

Who is the culprit at this juncture? Kotak Mahindra Asset Management Company, which has a product “Kotak FMP series 127”, was due for repayment (to its investors) on April 8, failed to repay the amount. Fixed maturity plans which are close-ended debt funds with a maturity period ranging from one month to 5 years are seen as an alternative to fixed deposits. To put it simply, the fund house collects a small sum of money from every investor wanting to invest in an FMP product for 1 year and consequently the fund house invests the same amount in a debt instrument (certificate of deposits, commercial paper, non-convertible debentures) of the same tenure (1 year). FMPs offer better post-tax returns than fixed deposits and also offers tax indexation benefits. The default will certainly be a jolt for the investors, corroborating the statement that “Mutual Funds are subject to market-risks, please read the offer document before investing”.

Reason behind the default?

Kotak Mahindra Mutual Fund, along with other fund houses had invested in instruments of Essel-group promoted companies which were backed by one of the group’s strongest media house “Zee”. Here, the term “backing” means that the lending was secured on the back of shares of Zee which were pledged to the fund houses. As some of these group entities defaulted on its payment obligation, the mutual fund houses were pressured in paying back the invested amount on maturity. What is interesting here is that the fund houses could have recovered the dues by selling shares which were pledged by Zee. But the significant fall in the share price of Zee made it difficult for fund houses to sell the shares as they would not have been able to recover the entire amount to be repaid to investors of FMP.

Diagrammatic presentation of FMP product with pledging shares

Who all are in the trap?

There are 94 FMPs have exposure to the Essel group companies. Kotak FMP has an aggregate exposure of Rs. 1,673 crs in the group entities as on December 2018. Kotak has denied its investors full payment of the payment obligations due in April and May’19 on the FMP product linked to Essel-group. Simply this means that the fund houses have not been able to pass on the amount which has not been received from these defaulting entities. On similar lines, HDFC Mutual fund, which is also a culprit in these scheme of things and has Rs. 902 crs invested in these FMPs, has told its investors to roll-over this scheme for another year i.e the fund house will make full repayment to investors due one year later from now.

What’s in store for the investors now?

The investors are now placed like the Royal Challenger’s Bangalore team in IPL where at the moment have lost their money and only time will tell whether they will recover from this precarious position. The only silver lining is that the Zee group is a good brand and have cash worth Rs. 1,200 crs in their books which assures the investors that the money will come back. Post this event the investors only have the wait and watch strategy to follow and for experience, the investors much note that debt funds providing higher returns come with high risk component. Such debt funds should not be compared with fixed deposits which are safer products.

The biggest take-away from all this for investors is that nothing is safe in the credit market: not even in the money which you lend to your beloved friends. On a lighter note, can investors invest in the safest asset of government treasuries or will there be a time when even they will default? Hope the central bank never lets this happen!!

Sushant Hede

14^th April, 2019

RBI’s MPC highlights the googlies to watch out for!!

Any surprise from the central bank this time around? Not really as a rate cut was widely factored in by the markets immediately prior to the first bi-monthly monetary policy for the financial year. On the policy front, there were only two questions which could have got monetary policy enthusiast interested: One, whether the rate cut would be as bold as 50 bps or mild as 25 bps? Two, in cricketing analogy similar to the one used by Dr. Viral Acharya, whether the members would decide to get out of the crease and push for an” accommodative stance” indicating a more dovish policy going forward?

These question get validation from the vote count as the rate cut was not unanimous in favour of a rate cut (4-2) and also the vote count on the stance (5-1), reflective of the constructive disagreement among economists. However, what is prominent is the “Dravid-style” resilience shown by Dr Viral Acharya and Dr. Chetan Ghate in voting against the rate cut despite slashing the inflation forecasts by 30-40 bps and growth forecast for FY20 by 20 bps from the previous policy. Though the minutes are released after a gap of 15 days, it would be interesting to see the rationale behind the decision. Both certainly see an upside risk to inflation in the forthcoming months which back their decision.

A disagreement between the MPC members indicates that there is no level playing field for the members to take unanimous decision. Four interesting things in today’s policy which needs to be accentuated are:

• The hazy nature of crude oil price: The price of India’s most important imported commodity been as whimsical as women’s shopping brain driving inflation prints and forecasts hay-wire. The average y-o-y growth in crude oil prices (Brent) seen at around 45% in the first seven months in FY18 (Apr-Oct) led to the fuel component of CPI rising to 62 months high. A reversal in trend in Dec’18 and Jan’19 (contraction on an average of 13%) dragged the fuel component to a multi years low. Given this wide divergence, what is even more critical is the cloudy forecast of crude oil prices with either upside or downside risks. Crude oil prices at the moment are placed on the weighing scale with an uncertain demand condition amidst global economic slowdown on one side and supply cuts by OPEC on the other side, keeping the crude oil prices and consequently inflation prints at bay. 
• Food prices and monsoon: Food inflation has been in the negative territory since Oct’18 chiefly owing to supply glut in several food items at both domestic and international level. The reversal in vegetable prices in summer months and weaker momentum of deflation in other food groups could see the food prices in the positive territory. However, the weather forecast shows El Nino conditions strengthening which could affect the south west monsoon. A weak monsoon could adversely impact food production aggravating the prevailing rural distress and slowdown in agriculture gross value added (GVA). On the other hand, lower production could push up prices seeing an uptick in the food component of CPI. The committee having assumed a normal monsoon while forecasting inflation, keeps the inflation forecast almost 1% lower than the target for H1-FY20. But the interesting part will be the H2-FY20 food inflation, which on a low base and weak monsoon could exacerbate headline inflation.
•  Transmission and Liquidity: The one main reason which the central bank governor state in going against the 50 bps rate cut is a “soft transmission effect”. A 25 bps cut in the previous MPC incentivised banks to cut interest rate by 5-10 bps in the subsequent months. To bolster interest rate margins, the banks gains by lowering interest rates on deposits relative to loans in a falling interest rate regime. While interest rates transmission is faster on loans relative to deposits in an increasing interest rate regime. Falling interest rates does not attract the depositors eye. Lower attraction for deposits and higher credit disbursement could add to the concern of liquidity deficit in the banking system (stressed since Sept’ 18). RBI has however on a regular basis stringently monitored the liquidity position by infusing durable liquidity aggregating almost Rs. 3 lakh crs by open market operations (OMOs) and undertaking a long term rupee dollar swap of $ 5 Bn in FY19 infusing Rs. 35,000 crs in the banking system (RBI is also going to undertake rupee dollar swap of $5 Bn in April’19). A liquidity deficit in the banking system makes transmission of interest rate difficult and could see further liquidity infusion via OMOs to aid transmission.
• Global growth slowdown and change in stance by central banks of advanced economies; If slashing of growth projection for the Indian economy by multilateral agencies and central statistics office is a concern on the domestic front, the slowdown in growth in advanced economies and emerging economies has had second order effects on the Indian economy (especially via exports). The inverted yield curve in the US and negative yields in Germany are indicative of a possible recession going ahead (with some lag). This has led to a compete U-turn by major central banks moving from a hawkish stance in Dec’8 to voices of a possible dovish stance in the forthcoming policy announcements. With global growth flashing red signals and major central banks turning dovish, it would be interesting to see if RBI follows suit.

The RBI has cut its key policy rate for the second time in this calendar year. There could not have been a better time to cut policy rates with a need to stimulate growth and with inflation prints and forecast remaining below target amidst declining inflation expectations. However, monsoon, crude oil prices, liquidity and global growth concerns are the googlies which the central banks needs to carefully monitor to avoid being clean bowled!

Sushant Hede

4th April, 2019