While the stance and rate action was expected, what was unexpected was the clear communication from both the Governor and the deputy Governor on liquidity measures and future rate stance.
There has been a sea change in the entire macroeconomic backdrop both in India and the global markets in the last 45 days. There was a considerable disappointment in the markets during the October monetary policy following a pause in the interest rate and the rupee seemed to be flying off the handle.
Cut to December and oil prices have fallen by around 30 percent, the rupee has appreciated, there is an evolving global growth scare that is gathering pace and the Federal Reserve has softened its stance on the extent of rate hikes needed to approach neutrality. Add to this, the ebbing inflation pressures and you get a perfect combination for a bullish view on all asset classes.
In the above backdrop, the Monetary Policy Committee (MPC) on December 5 kept the policy rate unchanged at 6.50 percent and retained the 'calibrated tightening' stance. These were very much in line with expectations. Retaining the stance is a prudent move considering the uncertainties for inflation from oil price volatility and food prices remain high.
While the stance and rate action was expected, what was unexpected was the clear communication from both the Governor and the deputy Governor on liquidity measures and future rate stance. Of course, the downward revision in Inflation trajectory was also far more than what anyone had expected.
Inflation forecasts have been revised sharply downward as expected and H2 FY2019 forecast now stands at 2.7-3.2 percent as compared to 3.9-4.5 percent earlier, which is similar to our own forecasts as well. The RBI has also provided H1 FY2020 forecast for CPI which is also fairly benign at 3.8-4.2 percent and is in fact, slightly lower than our expectations.
The post-policy conference provided other valuable insights whereby the Governor confirmed that if the upside risks to inflation do not fructify then there remains scope for a change in policy stance. This should give comfort to the market that if the actual inflation trajectory were to confirm what is being projected then the MPC would be willing to review the rate action. The policy and the post-policy phrasing seem to indicate that the MPC would like to see the sustainability of the low readings of inflation before reassessing the stance and rate action.
Moreover, the RBI also highlighted the possibility of further Open Market Operation (OMO) purchases till March and seemed to allude to an increase in the pace of the operations in order to meet the liquidity requirements of the banking system. We feel the gradual increase in currency in circulation and the buildup of government balances towards the end of the fiscal year will both lead to a withdrawal of liquidity that will have to be balanced by OMO purchases and long-term repos. This will impart some amount of positivity to the bond markets.
The move to cut Statutory Liquidity Ratio (SLR) was done with the idea of freeing up more resources for enhanced lending in the productive sectors of the economy. The OMO purchases are likely to make this move more effective as the collective banking system has the opportunity to offload excess SLR to the RBI. Since the impact of SLR cut has been tapered over six quarters the markets have enough time to absorb the reduction in statutory demand for government bonds from banks.
Fixed income markets have got considerable support from today’s developments to at least anticipate no further action for the next six months and also entertain the possibility of a rate cut if circumstances should so align. We, however, feel it is too early to call for a cut and would tilt more in favour of a stance reversal before any such action materializes.
Sovereign yields and interest rate swap curves had already started reflecting this improved sentiment and will continue to do so as witnessed in the around 10 bps intraday fall in the benchmark yield.
On balance, the view on Indian fixed income for at least the rest of this fiscal seems to be fairly constructive with support from continued OMO purchases, very benign inflation outcomes, clarity on tools to address system liquidity (combination of OMOs and long-term repos), supportive demand-supply framework and benign monetary policy. The bulk of repricing would happen first in the sovereign curve and the benchmark 10Y yield could move towards the 7.20-7.30 percent mark.
Subsequently, over the next few months when the NBFC stress is mitigated, we would see renewed demand for spread assets accompanied by some spread compression. The interest rate swap curve up to one year has already seen substantial receiving pressure and is currently not pricing any further policy rate action. We expect the rupee to also be supportive and trade in a range of around 69.50-72.50.
No outlook for asset classes is free of risks, especially in a volatile market like ours. In the very near term, the outcome on oil prices will be crucial for both bonds and rupee and December 6 OPEC meeting will decide the near-term trajectory. On the domestic front, fiscal concerns are still rife and could resurface soon. However, breaches on deficit might not be financed by extra borrowing and a combination of expenditure shifting/cutting, rollover and/or other financing options would be employed.(The author is group executive and head, global markets group, ICICI Bank. Views are personal)