• Repo rate raised by 25bps to 7.5% with immediate effect.
• Reverse Repo rate up by 25bps to 6.50% with immediate effect.
• Marginal Standing Facility (MSF) adjusted to 8.5% with immediate effect.
• CRR & SLR rate kept unchanged at 6.0% & 24% respectively.
Policy Stance:
The RBI in its mid quarter policy review has hiked the repo rate by 25 bps to 7.5%. Post the hike in repo rate, reverse repo rate stands at 6.5% and the marginal standing facility rate at 8.5%. The hike in policy rates is in line with market expectations. With the hike in policy rates the RBI has reiterated its anti inflationary stance.
The RBI has not made any changes to the economic outlook indicated in the Annual Monetary Policy statement declared on May 3, 2011. While the RBI acknowledges the fact that rate hikes may lead to some deceleration, but it does not expect a sharp broad-based slowdown in the domestic economy. With the RBI not expecting a severe slowdown, it will continue to tighten monetary policy to tame inflation.
Although the RBI intends to curb the consumption demand by hiking the policy rates, the latest GDP numbers for Q4 FY11 indicates slowing investment demand. Though the RBI has identified the fact that “some short-run deceleration in growth may be unavoidable in bringing inflation under control”, the impact of hawkish monetary policy stance on investment cycle may lead to higher than expected slowdown in growth numbers. In the given context, we believe RBI might be nearing the end of tightening cycle.
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Macro Indicators:
The RBI has left its GDP growth projections unchanged, but it highlights the downside risk to economic growth emanating from deterioration in the global macro economic environment. Though the signs of moderation in the economic activity are visible in some sectors, the broad indicators of activity – Q4FY11 profit growth & margins and credit growth do not suggest a sharp or broad-based deceleration.
On the inflation front, the RBI continues to believe that domestic inflation risks remain high. The headline numbers (WPI at 9.06% in May06) understate the pressures because fuel prices have yet to reflect global crude oil prices while the recent declaration in global commodity prices is too early an indicator to downgrade it as a risk factor.
Given the policy stance of ‘firmly anti-inflationary’ in a environment of broad-based domestic inflation,which is yet to see adjustment of fuel price, the RBI would be propelled to take gradual steps to raise rates.
Though the inflation continues to be a prime concern in the near term but few factors that may play out for moderation in inflation (Q2 onwards) could be – a) moderation in global commodity prices, b) normal monsoon c) high base affect and d) lagged impact of monetary tightening. Over the medium term, these factors would be critical to form the policy stance.
Having said that, it would be challenging for RBI to continue with its anti-inflationary stance and the extent of policy action needs to balance the adverse movements in inflation with recent global developments and their likely impact on the domestic growth trajectory.
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Impact on Debt Market & Strategy:
The monetary policy was broadly in line with the market expectations. In reaction to the policy announcements, the 10year benchmark gilt has eased 8-9bps to 8.31% levels while short term yields are hovering closer to their previous day closing level.
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In the short to medium term, factors such as inflation and supply-demand dynamics to influence the longer end of the curve. Having said that, Inflation may continue to stay stubborn till Q2 FY 12 and on the supply side - govt is yet to complete its borrowings of about Rs. 3.0 lac crores in FY12. Already, with completion of about 30% of the govt borrowings, the yields at the longer end have inched up by 40-50bps since April,2011.
Additionally, the inverted yield curve may entice RBI to load the borrowings at the longer maturities, which may further exert pressure on the longer end of the curve. With respect to the supply, the demand seems lackluster as evident from the recent auction bid ratios coupled with bank’s SLR above 28%.
However, if the deposit growth revives then it may create demand for the g-sec by banks to maintain SLR and to have access to Repo window, the banks may continue to maintain higher SLR ratio. In this backdrop, we expect the longer end would continue to remain volatile with an upward bias as negative factors may overwhelm intermittent respite factors.
The shorter end of the curve may take direction primarily from the liquidity conditions, which continues to stays into deficit mode above Rs. 60,000 crs. Few factors that favor the liquidity scenarios are – a) govt cash turning into deficit of about Rs. 29,000 crs in Q1FY12, b) RBI norm on investment cap by Banks in Liquid funds may free approx Rs. 40,000-50,000 crs and c) initial signs of improvement in deposit growth and money supply. Such factors may result into intermittent easing of yields. However, the RBI would like to maintain the systemic liquidity into deficit for effective transmission of policy. So, given the hawkish stance by RBI coupled with broad systemic liquidity deficit, we do not expect yields of short maturity papers to move down significantly from current levels.
Strategy:
The upside risk to inflation, hawkish policy stance by RBI, tight liquidity conditions and uncertainty in global commodity prices may keep the yield curve inverted in the near term. However, in the longer term, factors such as deceleration in global & domestic growth, moderation in global commodity prices and normal monsoons indicate that RBI could be nearing the end of the tightening cycle, which would then normalize the shorter end of the curve. In such a scenario, we advise investors to capitalize on the inversion of the curve and stagger their investment to capture higher accruals while curve normalization may potentially accrue capital gains as well.
Impact on Equity Market:
The equity markets were not exposed to any shock with regards to the quantum of rate hike. The effective rise of 25 bps in policy rates was in line with market expectations.
Though the rate hike is line with market expectations, the guidance given by RBI with respect to inflation outlook and also the continuance of hawkish monetary policy may not bode well for the markets in the near term.
The rise in rates will not only impact the consumption demand but can also lead to further slowdown in investment demand, signs of which are already visible. Higher than expected impact of rising interest rate on growth rates can have a negative bearing on the markets and can also lead to lackluster FII flows.
Given the rise in interest rates and expectations of further rise, interest rate sensitive sectors may continue to be out of favor. The high yields offered by debt instruments could further impact the already dormant flows in equity markets.
In the wake of domestic and global headwinds, the investors should focus their portfolio in favor of large cap diversified equity funds.
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Thanks
Ankit Wani
Intern @ DENIP Consultants Pvt. Ltd.
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