Frontier market fund forecasts ‘lower-for-longer’ for Sri Lanka

• Tundra Fonder says CB would be cautious to change course given the magnitude of crisis 
• Says lower bond yields have swayed local investors towards equities 
• Believes local investors to call shots in the equity market despite foreign selling 

Lower interest rates could stay for longer in Sri Lanka than in previous instances as Central Bank would be more cautious in changing track given the scale and magnitude of the economic shock dealt by the pandemic, says Tundra Fonder, the Swedish asset manager specialising in frontier and emerging market including Sri Lanka. Central Banks around the world, including that of Sri Lanka, turned unusually dovish, both at the onset and during the pandemic and assured readiness to provide unlimited support to their respective economies beset by the pandemic-induced shutdowns.  

This assurance has powered the advances in equities around the world, including that of Sri Lanka, as seen from the recent ascendency of the indices at the Colombo Stock Exchange as investors shifted from lower yield bonds to accumulating stocks due to the confidence that the Central Bank and the government stand ready to support economic recovery. Investors flock to equities as they are aware the lower rates will reduce borrowings costs of companies and induce consumer demand, both factors leading to higher earnings potential of entities. 

Since January, the Monetary Board has cut key policy rates by 250 basis points in five occasions, including the latest one yesterday, and reduced the banks’ reserve ratio by 300 basis points while releasing billions in liquidity to money markets. “Given the shock of COVID-19, we believe central banks will be cautious about raising too soon and may accept low real interest rates (interest minus inflation) for some time to come,” said Tundra Fonder in their June update.

If the Central Bank could stay lower for longer, that could provide the much needed certainty to businesses on their borrowing costs and gives the impetus to the equities market.

Sri Lanka typically has short interest rate cycles, which follow economic cycles, as lower interest rates often lead to spike in credit, which then fuels influx of imports and stoke inflation forcing the Central Bank to reverse course by way of raising interest rates. This time, unlike in the past, room to trigger a similar vicious cycle is limited due to import controls and targeted credit to productive segments. Inflationary expectations also remain muted due to below potential growth in the economy. 

“The big question will be at what levels long-term interest rates stabilize, which of course depends on the recovery in economies and the inflationary impact that will have,” Tundra Fonder added. 

Meanwhile, lower rates have already swayed the investors in Sri Lanka into equities, Tundra Fonder observed.  “In Sri Lanka, for example, the 10-year bond yield fell from 9 percent to 7.2 percent during the month. Lower bond yields have in turn meant that local investors have moved some capital from the bond market to the equity market”, it said. 

Hence they believe the trend would continue where local investors deciding the market’s direction although the foreigners continue to sell. 

“Thus, despite continued sales from foreign investors, local investors are currently deciding the direction of the market. We believe this trend will continue as long as bond yields remain at these levels, despite uncertain profit prospects for the current year,” Tundra Fonder added.