On Friday, October 25, at 13:30 Moscow time Bank of Russia (CBR) will announce its rate decision in a press release ahead of the last meeting to be held in December. Russia fiscal easing cycle rate is one of the lowest in the world amid global dovish trends and accelerated deflation. We believe that the Central Bank will accelerate policy easing, which means a bigger than 25-bps cut.
We expect good performance on the short OFZ curve — short-term bonds have hit yields lows preceding the sanctions against Rusal (April 6, 2018). It is also reasonable to take a closer look at investment grade corporate issues under four years maturity, the offer included.
How well the rate cut is priced in what are the best trade ideas?
Based on the current short-term OFZs with 5.9% annual yields an aggressive interest rates cut has not been priced in yet, and the market is hardly expecting a bigger than 100-bps cut within 12 months. However we expect a 75-bps cut by the end of the year and another 75-bps cut next year, which will bring the rate to 5.5%, a level likely to hold until the end of 2020. Therefore, short-term OFZ yields downside is at least 50 bp, which implies long-term bonds price upside of 3–4%.
It is also reasonable to buy September 2020 futures for ROUNIA interbank rates (RUON 09-20), these rates are significantly higher than the key rate one and do not point to a more aggressive cut in the near future.
Moreover, inflationary OFZs reflect lower inflation decline rates than our actual estimates.
Impact on the rouble
If the rate is reduced by 50 bps, the primary effect for the rouble will be negative, but the Russian currency should recover during the day, so the final effect will be neutral. Overall, we believe that the current rouble rate is justified given the current oil price and risk demand.
Rate outlook until the year-end
Our optimistic/baseline scenario assumes that a 50-bps cut in October and a 25-bps cut in December, bringing a year-end rate to 6.25% instead of previously expected 6.75%. By the end of 2020, we expect a further 75-bps cut to 5.5% from projected 6.25%.
Of course, in case of revaluation long issues appear more preferable, but so far the focus is on the rouble bet, we believe the Russian currency rate is fair at the current oil prices.
Gap between nominal rate and inflation yoy, %
Why CBR in for an aggressive rate cut?
On Friday, October 18, Bank of Russia Governor Elvira Nabiullina said an interview with CNBC that the regulator is ready to act «more decisively» when cutting interest rates than previously planned (25 bps by the end of the year). Projected CBR nominal rate is now way below inflation forecasts, dropping to 4% yoy by the end of the year against initially expected 4.2–4.7% and lately-projected 4–4.5%. CBR regularly cutting its targets despite the key rate trend.
In September, the median inflation expectations of households dropped to 8.9%, hitting the lowest since June 2018, according to the CBR survey.
The Central Bank has calculated inflation slowdown rates based on a sharper drop of consumer demand and real disposable incomes, and is seeking to reduce the spread between the key rate and inflation, which has traditionally been higher in Russia as compared to other countries. Now the gap stands at 300 bps, the highest since late 2018.
At the same time, real income grew 3% in Q319, the indicator has been declining over the past few years, including previous quarters.
In addition to inflation, dovish Fed stance and global volatility decline (due to expected U.S. — China trade agreement and Brexit deal) play an important role.
Real inflation and households expectations, %
Source: Bloomberg, ITI Capital
How well the rate cut is priced in?
Based on the prices and yields performance ytd, downside is limited and already priced in. The current Russian sovereign bonds yield just over 6%.
At the same time, interbank rates offer a good premium, slightly exceeding the key rate, reflecting conservative expectations for the rate.
Source: Bloomberg, ITI Capital