June 20, 2019

OFZ: Supportive Combination

BY Alexander Kudrin, Evgeny Gavrilenkov

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The recent CBR decision to cut the key interest rate and its generally dovish comments about the future direction of the monetary policy may support demand for OFZ from international players. If we take into account the high chances of the further contraction of the US interest rates in the near future, then the inflow of foreign money may easily beat the regulator’s relatively moderate expectations. Simultaneously, start of the rate cut cycle is likely to bring down the cost of funding for commercial banks, which will also be supportive for ruble bonds. In general, the OFZ yield curve still has potential for compression which can materialize within next several months.

  •  Last Friday, the CBR decided to cut its key rate from 7,75 to 7,5%, which was largely expected by the market as the CPI growth in Russia had started to decelerate and the annual inflation moved down to 5% in early June. The market seems to treat the regulator’s recent decision as the sign of the beginning of the rate cut cycle.
  •  The CBR expects the key rate to become “neutral” (2-3% in real or 6-7% in nominal terms) closer to mid-2020.
  •  If we take into account the high chances of the US rate cuts in 2H19, then the moderate growth of the foreign OFZ holdings seems to be the base case scenario. We think that it may reach R2,8-2,9 trln by the end of the year (vs about R2.5 trln as of Jun 1).
  •  The decreasing cost of funding on the money market is likely to fuel demand for OFZ from Russian commercial banks.
  •  If key rate drops to 7%, then the 10-year OFZ yield may decrease to 6.86.9%. We do not rule out that this level may be achieved even in 2H19.
OFZ: Supportive Combination 8

CBR decision: a dovish tone

Last Friday, the CBR decided to cut its key rate from 7,75 to 7,5%, which was largely expected by the market as the CPI growth in Russia had started to decelerate and the annual inflation moved down to 5% in early June. As the previous GKEM Analytica report mentioned, it was not the falling inflation alone which encouraged the CBR to act, but also the need to gradually eliminate some distortions which stem from a too peculiar combination of a too tight budgetary and monetary policies, negatively affecting the economic growth.

OFZ: Supportive Combination 9

Simultaneously, the regulator made quite a dovish statement which particularly mentioned that the timing of the expected switch to the “neutral” monetary policy had shifted from the end of 2020 to mid-2020. To remind, a “neutral” policy assumes that the real interest rate should stay in a 2–3% range. If we take into account that the CBR’s longer-term CPI growth target is 4%, it translates into the nominal key rate of 6-7%. Assuming no major global or external shocks going forward, the latter means that the key rate can be cut by 50-150 bps within the next 12 months (which are likely to include eight CBR BoD meetings). Thus, the regulator might probably cut the rate by 25 bps every second meeting. Market seems to treat the regulator’s recent decision as the sign of the beginning of the rate cut cycle (if inflation decelerates rapidly and remains low, then even a one-off 50 bps cut is possible).

Foreigners

International investors have significantly increased their presence on the OFZ market. According to the CBR, their OFZ holdings set a new record high in nominal terms as of June 1, but are still below the historical high in relative terms. We estimate that the foreigners share of the OFZ market will reach 30.6-30.8% as of July 1, while the historical high was recorded in Apr 2018 – 34.5%. As noted in previous reports, we do not think that the inflow of foreign capital into the ruble bonds is going to remain as intensive as it was in the first five months of the year, but a drastic switch to outflow is also not very likely (again, assuming no major global shocks occurring in the foreseeable future). If we take into account the high chances of the US rate cuts in 2H19, then the moderate growth of the foreign OFZ holdings seems to be the base case scenario. We think that it may reach R2,8-2,9 trln by the end of the year.

OFZ: Supportive Combination 10

The regulator is sticking to a more conservative approach. According to its estimates, the foreign holding of sovereigns (including Eurobonds) in net terms may grow by $3 bln in 2H19 and by $6 bln annually in 2020-2021. Even if we assume no new issue of sovereign Eurobonds (where foreigners were buying on average more than 80% in 2018-2019), then this forecast seems to be too pessimistic.

OFZ: Supportive Combination 11

The demand for defensive EM assets is likely to increase in coming months. A high level of uncertainty regarding the global economy performance stimulates investors to stay more cautious. The combination of a low debt burden and a high amount of international reserves makes Russian hard currency sovereigns a typical defensive asset, even if somebody expects oil prices to drop in the near future. The only point of concern is geopolitical risks. However, this category has lost much of its importance in the last several months as the US politicians had begun to focus more on Iran and China. As a result, Russia’s CDS premium started to move down. Given the fundamental strength of the Russian credit, it is not a big surprise that foreign investors were increasing their positions in Russian sovereigns on the back of a growing uncertainty in global economy. We think that this trend may continue in 2H19 and that the sovereign Eurobonds international holdings may go up by $2.5-3 bln. The total inflow of international money into Russian sovereigns (both ruble and hard currency) may be estimated at $5.5-6.0 bln, which is twice as much as the regulator expects it to be.

OFZ: Supportive Combination 12

Local banks

The decrease of the key rate is likely to bring down the cost of funding for local commercial banks. Moreover, many of them are likely to price in a further contraction of the interest rates on the money market in line with the softening of the CBR monetary policy. If so, a certain demand from their side may appear even in the long end of the yield curve, which is attractive in terms of carry trade (it was indirectly confirmed this week, when the 10 year OFZ yield dropped below the key rate). As a result, commercial banks are likely to show net inflow into OFZ in 2H19. However, we do not think that the overall amount of the Russian banks’ investments in OFZ will grow very rapidly as problems with the ruble liquidity are still in place (please see the previous report by GKEM Analytica) and will definitely depend on the Sovereigns’ premium over the expected money market interest rates.

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The yield curve

The OFZ yield curve still has a certain potential for compression in light of potential decrease of the key rate. The average spread between the 10-year synthetic OFZ yield and the key rate during the last five years was about minus 40 bps. The latter means that if the key rate is moving down to 7% (the upper level of the “neutral” range by the CBR’s definition), then the 10-year OFZ yield may drop to 6.6%. But this level seems too low given the relatively high cost of funding for commercial banks and the lack of room for further yield compression from there, which limits the speculators’ appetite.

However, we think that another historical pattern is more likely. In the newest history of the market the key rate was fluctuating between 7.25 and 7.5% in 2018. During this period the 10-year OFZ yield traded between 7.1 and 9.3%. So, if we assume the key rate to move down to 7%, the OFZ yield may drop to 6.8-6.9%. We do not rule out that this level may be achieved even in 2H19, and the expected inflow from Russian institutional investors (which traditionally peaks in 2-3Q) may support this trend. The biggest obstacle for that is the potential supply of new paper from the Finance Ministry. On the one hand, the government has already demonstrated some signs that its appetite for issuance is moderating. The ministry recently said it planned to return (partially) to pre-announcing the placement limits for certain auctions and used this approach during the recent placement, where the maximum amount of issuance of plain vanilla bond was set at R20 bln. On the other hand, the borrowing program remains ambitious and hence the presence of the potential supply may prevent OFZ yields from moving down.

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Data provider: Cbonds

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