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A Consensus Hike

Posted On Thursday, Jun 07, 2018

The MPC (Monetary Policy Committee) of the RBI finally voted unanimously, this time, for a rate hike. It was a 6-0 decision to hike the Repo rate by 25 bps to 6.25%.
This 25 bps rate hike by the RBI, the first in four and a half years, should be seen as a reversal in the interest rate cycle.

Bond markets have already priced in a 50 bps rate hike and thus we do not see much impact on bond yields from this rate hike. The 10 year bond yield did go up by 6 bps post the policy but more in response to lack of clarity on OMO(Open Market Operations) purchases and also due to the changes in Liquidity coverage ratios which will potentially affect demand for long term government bonds.

India government bond yields now at around the 8.0% mark and the shorter end AAA PSU corporate bonds at 8.5% have priced in significant uncertainty risk premium. Uncertainty on Oil prices, foreign investor behavior, rupee movement, liquidity actions. Also there is uncertainty on RBIs response to these factors.
RBI’s communication remains confounding for the market and until the markets gets used to this, the bond spreads will remain high.

The uncertainty risk we see from this policy is on the stance of the monetary policy. The RBI has hiked the Repo rate but retained its stance at neutral which suggests that it wants the flexibility and be data dependent. It also conveys that we may not be in a long rate hiking cycle and the rate hikes are more pre-emptive against emerging inflation risks.
But what if the CPI trends above 5.0%, the stance may then be changed to tightening which then brings in market uncertainty on whether this will be a larger rate hiking cycle of 75-100 bps.
We expect another 25 bps hike in October but above that will be contingent on even higher oil prices and poorer monsoon.

The bond market, suffering also from poor demand, was expecting more OMO (Open Market Operations) purchases (RBI buying government bonds) to help support the market.
Dr. Patel though belied those expectations by suggesting that as weighted average call rates remain below the Repo rate, liquidity conditions remain comfortable.

We differ with RBI on this assessment of their liquidity. Weighted average call rates (decided by the banks as only they are allowed in the call money market) cannot be the only parameter of judging liquidity conditions. Money Market Rates which is reflective of the entire bond market participation is signaling tighter conditions and asymmetric liquidity situation.

So although, the overnight call money rate remains close to the Repo rate, the 3 month T-Bill rate has climbed to 6.5%; the 3 month Bank Certificate of Deposits (CD) rate is at 7.0% and 3 month AAA rated Commercial Paper (CP) rate is at 7.5%-7.75%. These are indicative of some stress in the liquidity scenario and the RBI does need to come out with measures to address this situation.
Market interest rates are tighter and higher than what the RBI would like it to be at the current growth and inflation environment.

The liquidity response need not be only through OMOs, but to recollect, the RBI then under Dr. Rajan, did exactly the same thing in April 2016, when they acknowledged the stress in money market rates and used OMO purchases to move liquidity into neutral situation.

Today, although the overall liquidity situation appears in surplus, but pockets of PSU banks under Prompt Corrective Action (PCA) cannot lend and have surplus liquidity while some other banks witnessing credit growth do not have that excess liquidity. If the RBI indeed acts on the liquidity front in an assertive manner, we would see short term market interest rates falling sharply from its current levels.

Another factor which will aid short term rates is the statement made by Dr. Patel on the use of the interest rates to manage currency. Given the sharp depreciation in the Indian Rupee, markets had started to fear that the RBI may have to hike rates as they did in July 2013, when they hiked the MSF rate by 300 bps overnight to defend the currency and flush out speculators. We believe, given where the short term yields are trading, the markets were pricing in such an eventuality.

But Dr. Patel in the post policy press conference, very clearly stated that "Our monetary policy is determined by the Consumer Price Index and that we will internalize the impact of currency depreciation in our inflation projections", moreover suggesting that they don’t intend to use interest rates as a defense against currency depreciation.


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