Since Raghuram Rajan has taken over as the RBI governor he has put out a clear unambiguous vision of working on getting inflation down to reasonable levels in India over the next 2-3 years. He has also shifted the centre of inflation targeting away from WPI to CPI, which is a debatable move given the way CPI is calculated in India and an element of randomness in the data. However in the absence of anything better that is the best strategy. Hopefully the data quality will improve over a period of time.
In general the move to keep money tight is perceived to be negative for bonds. That is true in the short run. However the objective of this is to bring long term inflation and more importantly inflation expectations down. If this aim is achieved then we will actually see long term bond investors laugh their way to the bank.
An example of this has already been seen in several other economies, especially the USA. Subsequent to the inflation spike in the United States in the 1980's and early 1990's a tight monetary policy combined with an improving Fiscal Position led to inflation come down significantly from over 10% to an average of 2-3%. This was aided by several factors which included huge productivity improvements due to the technology boom as well as the emergence of China as the supplier of cheap and even cheaper products to the global marketplace. The impact of this was two fold. Not only did inflation come down but also inflationary expectations came down. As inflationary expectations come down the demand for higher wages comes down and the propensity of companies to increase the price of their products also reduces. This ultimately leads to huge profits for long term bond investors as bond yields come down.
The disadvantage of inflation that remains high for a prolonged period of time is that consumers in the economy expect that inflation will continue to remain high even in the future. The demand for higher wages and the propensity of companies or service providers to increase that cost of their services is also high as they expect that future inflation will cut into their profitability and as such most try to pre empt the same and increase prices. This is visible in India today as a prolonged period of high inflation has led to a situation where the expectations for high inflation in the future are very high. There are various factors which have led to prolonged period of high inflation in India the primary among them is long period of Fiscal Profligacy especially in non productive revenue expenditure combined with a lack of productivity improvements in large segments of the economy. The rapid and continuous increase in Agricultural Minimum Support prices over the last 5 years has also contributed to higher Consumer Prices as CPI has a 50% weightage of food. The continuous weakness of the Indian Rupee has also contributed to higher imported inflation. It is obviously debatable whether the debasement of the value of the INR is due to higher inflation differentials or INR fall has led to higher inflation.
There is now an opportunity for Raghuram Rajans gambit to playout. However this will not be possible without the support of the new Central Government. Continued Fiscal Profligacy combined with an increasing propensity to postpone reforms will lead to a slow progress in inflation control. One factor that has also contributed to higher headline inflation has been an adjustment of regulated prices especially in the power and fuel sectors. These adjustments are now on the verge of getting over to a great degree. One big area of adjustment left will be of fertilizer subsidies which the next government will need to take on board.
Rajan's resolve has been taken well by the markets and we have seen the debasement in the value of the Indian rupee stop and reverse. The general belief that the strategy to control inflation is a long drawn and consistent one unlike half baked measures of the previous RBI governors has already started playing out on inflation expectations.
If we are to assume that the average CPI of 2013-14 of around 10% will actually fall to 6% over the next two years then this will also mean that the 10 year bond yields will also fall from the current 9% to below 7%. If this is also combined with an improving economy and an improved Fiscal Position the rally in bond prices can be even sharper. If a zero coupon 10 year bond that yields 9% today yields 7% after two years and has a residual life of 8 years then for investors who invest today it will provide a capital appreciation of 38% over a 2 year period. If yields fall to 6% then returns will be a whopping 48%. Essentially a monetary policy that is assumed to be tight and bad for bonds today is actually very good for long term bond investors if the aim of the policy is achieved.
There will be people who will argue that as US bond yields move up with the end of Taper and easy money policies and a revival of the US economy it is unlikely that bonds will rally in India. This is an extremely fallacious argument. Over the last 15 years the difference in bond yields between Indian 10 yr and US 10 yr has been as low as 1% and as high as 7%. The current differential is in 6.25%. There is no reason to believe that it will not compress. Also given that the Indian government is largely financed by domestic investor's domestic macroeconomics is much more important from the standpoint of Indian yields.
In conclusion, the possibility of a stable growth oriented government combined with a credible central bank is actually very bullish for bond investors. The possibility that both bond and equity investors will make lot of money over the next two years will in that case be quite high.