Incredibly, the Russian central bank has become one of the country’s strongest institutions – not only domestically but as well when compared to other emerging market (EM) central banks.
President Putin and other government leaders have respected central bank decisions and refrained from any public exertion of pressure over the past three years, even during the height of geopolitical crisis. Central Bank of Russia Governor Elvira Nabiullina allowed a large depreciation in the Russian rouble (see exhibit 1 below), managed to raise interest rates aggressively in 2014 and refrained from reversing course until inflation has subsided – all textbook responses to a terms of trade shock that have nevertheless proven exceedingly difficult for other countries’ central banks to undertake.
Exhibit 1: The Russian rouble has undergone a major depreciation versus the US dollar (graph shows number of roubles per US dollar for the period from December 2013 through 18/05/16).
Source: Bloomberg, as at 18 May 2016.
This episode now creates an opportunity for impressive interest rate cuts, owing to three factors. Most intuitively, conservative monetary policy with a bias to anti-inflation decisions allows for the central bank to undertake a full cycle of easing without risking a relapse of inflation risk or vulnerability. Second, inflation expectations are likely to remain anchored, built on a pattern of stability and prudence, reducing inflation risk premium along the curve. Last, enhanced central bank credibility under Nabiullina helps compress term premium and can allow for a lower neutral real interest rate level over the longer run. Having taken advantage of the crisis to demonstrate orthodoxy and independence, the central bank in theory may even be able to guide real interest rates to an even lower level than before.
Exhibit 2: There is scope for the Russian central bank to cut the key official rate from its current level of 11% (the last rate cut was in July 2015).
Source: Bloomberg, as at 18 May 2016.
How can investors benefit from these changes? Local currency bond duration is one of the few unique alpha sources in EMs. Unique, we say, because it is uncorrelated to general risk factors that typically drive EM assets like currencies and credit. Also what one central bank does has nothing to do with another — or any other — central bank, even in a neighbouring country. Each country can exhibit its own local monetary dynamics and idiosyncratic set of domestic risks which, in theory, each central bank responds to according to its individual mandate and reaction function.
Russia’s ability to ease interest rate policy may sound counterintuitive at a time when EM credit risks are heightened, currencies have devalued sharply, and other countries – from Colombia to South Africa – are raising interest rates. Even specific to Russia, credit spreads have widened from 140 to 220 basis points and the rouble stands over 50% weaker compared to the eve of the taper tantrum that occurred in May 2013. Here, unique alpha plays out clearly: with Russian GDP (Gross Domestic Product) growth running -3.8% on a rolling year-over-year basis and inflation having declined to 7.3% on an annualised basis from 12.9% last year, conditions clearly permit a reduction in policy rates from 11% currently. Assuming inflation remains in a stable range, real interest rates now measure nearly 4% and could be reduced by as much as 400 basis points simply to match levels prior to the currency devaluation.
Why hasn’t this been priced in? In a world of perfect information, surely investors would have already incorporated the above views into their market pricing and potential gains would have been arbitraged away. However with the Russian yield curve yielding 9-9.5% across tenors, it’s clear that only a small easing has been priced. We note two phenomena at play here. First, investors appear to systematically underprice cyclical movements into asset prices. One interest rate cut or drop in inflation tends to be followed by additional changes in the same direction with a high probability in any given country, yet investors routinely ignore the autocorrelation and typically refrain from taking a view without infallible evidence. Second, hedging costs can be prohibitive. Rouble forwards cost above 10% to employ, such that the negative carry on a hedged bond position can be costly over anything but relatively short periods. In a market without liquid interest rate swaps, the trade can prove uninvestable for some participants.
We would be remiss in concluding without consideration of risks to the trade. Principally, oil prices are a key driver of the rouble, and a renewed drop in crude would almost certainly cause rouble weakness and renewed inflation pass-through. Geopolitics are unpredictable and any new conflict involving Russia could also cause term premium changes. We have low concerns regarding Russian domestic crisis risks or political instability that could feed through to central bank policy, but these are of course possibilities that investors should take into account. [divider] [/divider]
This article was written on 9 May 2016, in London.
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