Last week's podcast was on "Do not Position Portfolios Based on Central Bank Policies". RBI has just provided an example of how central bank policies can hurt your investments in the short term but for the long term fundamentals will come into play.
RBI's move to tighten liquidity in the system has led to bond/bond fund investors losing all the gains seen over the last one year. Many investors would have lost money if their entry point in bonds/bond funds were in the last four months, when the ten year bond yield fell from levels of 8 percent to levels of 7.10 percent. The ten year benchmark bond, the 7.16 percent 2023 bond is trading at levels of 8.10 percent post the RBI move on the 16th of July.
Bond/bond fund investors will obviously be nervous on their investments at present. It is difficult to predict where the ten year bond yield will go in this uncertain market environment. The normal tendency in such market conditions will be to take money out of the market and keep it in cash.
The RBI may have acted for the short term to prevent the INR from falling. However that does not mean that bond/bond fund investors have to act for the short term. In fact RBI has given a good entry point for fresh investments in bonds/bonds funds as yields have gone up by 100bps from lows seen in May 2013.
The long term view on interest rates has not changed despite RBI moves to curb liquidity in the system. The Indian economy is slowing down considerably and growth for 2013-14 could be even below the decade low growth rate of 5 percent seen in 2012-13. Consumer spending has come off with consumer durables seeing over 10 percent fall in growth in May while credit growth is at multi year lows of 13.7 percent indicating weak investment demand.
Inflation is seen trending higher for a couple of months as food prices and hike in administered fuel prices take up inflation. However, weak domestic demand coupled with weak outlook for commodity prices globally on the back of economic growth slowdown will keep inflation tempered.
The Indian Rupee will stay volatile given domestic and global uncertainties and the markets will learn to live with this volatility. The correlation between INR and inflation is not perfect and in fact WPI (Wholesale Price Inflation) has fallen from over 9 percent levels to below 5 percent levels even as the INR has depreciated by over 25 percent against the USD over the last couple of years.
The government on its part is looking to encourage FDI and FII flows into the country and is also making plans to raise USD funds through a sovereign bond issue or through a quasi guaranteed bond issue. USD bond issuance will lead to domestic government borrowing being restricted.
The long term outlook for bond yields is positive while the short term outlook is uncertain. Hence bond/bond fund investors with a longer term view should take advantage of this short term uncertainty brought about by the RBI. Gains will be much higher going forward with risk levels lower than what it was before the RBI action on liquidity.
Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors.