The RBI Monetary Policy Committee (MPC) unanimously hiked repo rate by 50bps to 5.40 percent with immediate effect – third time in a row (May - 40bps, June - 50 bps) - on Friday. This was in line with our base case assumption. The stance remained unchanged at “focus on withdrawal of accommodation”. The tone was balanced and similar to June, aiming to tame inflation and external risks.
The bond markets are also expected to have a dovish undertone, which did not materialise. To that extent, bond yields sold off by around 15-20 bps. We did not see any material changes to the inflation forecasts – FY 2023 CPI forecasts were retained at 6.7 percent. Likewise, the on-year GDP growth was retained at 7.2 percent for FY 2023. CPI has been above the RBI comfort zone in CY22 to date but it is showing signs of receding. Hence, the caution from the RBI's end is palpable.
The global scenario has changed quite a bit since last policy meeting. Talks of recession have been gaining momentum, crude oil prices remain well-behaved so far and global food prices have eased too. With this rate hike, the repo rate has now crossed the pre-pandemic levels – something which the RBI did allude to in the previous policy.
Thus while the rate hike process may not reverse anytime soon, the pace may moderate before a pause. The RBI turned accommodative when policy rates were cut to 5.75 percent in June 2019. It is fair to assume policy rates reach at least that level by March 2023 (our view is around 5.90 percent terminal rate by FY23).
What should fixed income investors do?
The yield curve has become reasonably flat (short end of the curve has moved faster than long end) making the mid-end of the curve quite decent to own. The four-year government bond is at around 7 percent levels, five-year is at around 7.06 percent and seven-year is at around 7.20 percent levels. Even if we assume a terminal repo rate of 5.90 percent, these levels may sustain.
The OIS (swap) curve is getting flatter – implying shorter cycles in rate actions. Market action is suggesting reversal in rates too, though with a lag. Hence one could use uptick in yields to allocate to fixed income in a staggered manner. Foreign portfolio investors (FPIs) have started nibbling in to India bonds – after six straight months of negative net sales. While the amounts are negligible, a case for FPI allocation in India bonds given the high carry remains strong.
Also read - RBI moves towards a positive real rate of interest
Categories like target maturity funds, dynamic bond funds and floating rate funds continue to be our chosen pick in such a scenario.
To add, one may look to tilt the investment balance in favour of actively managed bond funds as we expect the pace of incremental rate hikes to be recede.
Hopefully with such a balanced approach to deployment, one is not left high 'n' dry in their portfolio singing – “I keep praying all day all night long…. Hare Ram Hare Ram!!"
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