Debt Outlook

August 08, 2019
Quantum Fixed Income Team

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) decided to cut the Repo Rate by 35 bps (0.35%) to 5.4% as against consensus market expectations of 25 bps rate cut but short of consensus market positioning of 50 bps.

Shaktikanta Das, the Governor of the RBI, used the terms 'pre-emptive' to justify the 35 bps cut against the 25 bps but alluded that a 50 bps cut at the current juncture may have been 'excessive'.

So the market participants who expected a 50 bps cut seemed disappointed that the MPC found it 'excessive' and were left to wonder whether the next rate cut would be 15 bps (0.15%) or 25 bps or 35 bps again.

We have acknowledged that the MPC, being an inflation targeting committee, does have enough monetary space to cut the Repo Rate further. Over the last 3 policies, the MPC has forecasted one year ahead average CPI inflation below 3.5%, lower than its targeted mandate of 4% and thus the Repo Rate even at 1.5% Real Rate, can be cut to 5.0%.

With Inflation well under control, the last two policies have been about supporting growth. It is here that the MPC and the RBI seems at odd with market expectations. In the last policy, they cut the Repo Rate below 6% and turned accommodative but retained full year GDP forecast at 7%.

Today, in the backdrop of even weaker growth, they have reduced the GDP growth forecast by only 10 bps to 6.9%. So despite sounding very growth focused and accommodative, the RBI doesn't believe that the growth will remain low. They are forecasting H2 FY 20 GDP growth to be between 7.2%-7.5% (at full potential where output gaps would have closed).

The RBI Governor believes that the current growth slowdown is only cyclical and not structural and expects the cumulative benefit of lower rates, easier liquidity and fiscal support to get growth back on track.

As we wrote in our June 19 Post policy note that the Repo Rate being cut below 6% and the RBI turning accommodative has happened only twice before in the last 20 years. It is not a common occurrence and only a continued economic slowdown (like the one we saw in 2002-03) or a financial crisis (2008-09) made the RBI to cut well below the 6% mark.

The RBI is likely to become cagey and calibrated in reducing the Repo Rate from here on. They may indeed move focus to liquidity and transmission. Even without cutting rates further, the RBI by keeping the banking system liquidity in huge surplus can ensure further fall in bond yields, deposits and bank lending rates. The banking system works with a lag but slowly and surely they will keep cutting lending rates in the next 6 months. Bank Lending Rates have far larger impact on the economy than the RBI controlled Repo Rate.

From a bond markets perspective, we believe that the best in the bond market is behind us. Especially when seen through the 10 year government bond, which has now fallen from 8.25% in October 2018 to 6.25%. There may be more to go but we believe at the current levels, these remain tactical short term plays and do not demand structural (long term) allocations.

The yield curve (the market yield on different maturities) is likely to steepen (short term maturity yields will fall more than long term yields). Given the likelihood of excess liquidity conditions, investors in money market, overnight and liquid funds should also expect lower returns as money market yields are expected to move towards the Repo Rate.

We also continue to believe that the credit crisis which began in the bond markets in 2018 is not over yet and investors should continue to prioritize safety and liquidity over trying to earn high returns from bond funds in 2019.

Data Source: Bloomberg, RBI


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