Quantum View: RBI Cuts; Back to Neutral

The six member Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) voted 4-2 to cut the Repo Rate by 25 bps to 6.25% but they were unanimous in the decision to move the monetary policy stance to 'Neutral' from 'Calibrated Tightening'.
Dr. Viral Acharya, Dy. Governor of the RBI and Dr. Chetan Ghate, external member of the MPC voted to keep rates unchanged.

The cut in the Repo rate reverses the policy rate trajectory wherein the RBI had hiked the Repo rate by 25 bps each in June and August 2018.
Having kept the rates unchanged in its October (in what was a bold move) and in the December 2018 policy (wherein they had indicated the possibility of a rate cut in the next meeting), it has now obliged the market with a rate cut.

The MPC has used the available space to reduce the Repo rate by 25 bps while also moving its stance back to Neutral. Oil prices which had peaked in October fell sharply since then and Food prices have continued to remain low resulting in lower than anticipated inflation.

The MPC has markedly lowered their inflation forecasts for 2019. In fact, the thing to note is that the MPC now projects the Oct-Dec'19 CPI at 3.9%. As per the MPC, the CPI is thus likely to remain below its 4% target for the entire 2019. As they get more confident of that number being achieved, there would be scope for another 25 bps reduction in the Repo rate to 6.0%.

Ideally, such a forecast should have called for larger rate cuts. Even at 4% average CPI inflation, a Repo Rate of 6% provides a 2% Positive Real Rate. To recollect, the RBI desires a Positive Real Rate of 1.5% - 2.0%. If the Real Rate target is lowered, there would be space for more rate cuts.

So there remains scope for further rate action but which as of now the bond market does not seem too convinced about.
The (old) 10 year Government Bond fell by less than 10 bps post the 25 bps rate cut. At 7.5% yield, it now trades at a 125 bps (1.25%) spread over the Repo Rate.

Most market estimates of 1 year ahead CPI inflation is above the 4.0% mark and we believe that the RBI estimates seem aggressive as of now. Also, the bond market believes, as of now, this is anyways not going to be a deep rate cut cycle and thus market bond yields may not react by much.

The bond markets immediate worries would now move to the prospect of facing the high supply of bonds in the coming months. There is a significant increase in supply from not only government bonds but also from State governments and Quasi-Government entities (PSUs). This we believe will keep market interest rates and spreads wide. We also do not see any meaningful reduction in bank lending and deposit rates. Bank deposit growth is running lower than credit growth and hence banks are unlikely to cut Deposit rates.

With India entering an uncertain election cycle, foreign investor demand will also remain muted until there is clarity on the next government and its likely macro-economic policies. So despite, a general wave of bullishness towards EM on FED dovishness, India is unlikely to be a key beneficiary till at least May 2019.

We would also like to keep highlighting and noting, that the credit crisis that begun in the Indian bond markets in September is not over yet and Bond Investors should continue to choose Safety (over Credit) and Liquidity (over Spreads and Returns) while investing in Bond Funds in 2019.

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