If MSP hike impacts inflation materially, we could see another 25 bps hike by RBI

Kunal Shah

The Reserve Bank of India’s Monetary Policy Committee (MPC) unanimously voted 6-0 for increasing repo rate to 6.25 percent from 6 percent in its second bi-monthly policy for the year. The MPC maintained the stance as neutral and will continue to formulate policy basis incoming data points.

MPC has revised the inflation projection for FY2019 to 4.77 percent from 4.65 percent in April policy. The hike in rates and projection is largely basis jump in crude oil prices and higher core inflation at 5.2 percent.

Currency and bond markets were also watchful of any aggressive interest rate defense by RBI in the wake of pressure from the external environment.

Emerging markets (EMs) like Indonesia have already hiked rates to protect the currency and halt capital outflows. The inflation basis rate change by MPC is actually a healthy development, defying views of the crisis in the currency market.

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Kunal Shah

Fund Manager- Debt|Kotak Life Insurance

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The move will strengthen the credibility of inflation targeting framework. MPC maintains growth projection of 7.4 percent in FY 2019 and believes the closure of output gap; much contrary to April statements wherein MPC had acknowledged that long-term growth potential could be higher given structural reforms initiated in recent past.

Also, surprisingly the change in rates has come even when the uncertainties (sighted in April policies) are yet to emerge, especially on the formula of MSP hikes, possible slippage of fiscal deficit etc.

So the move appears to be largely driven by 10 percent jump in crude prices and 30bps hardening of core inflation since April policy. So, if the MSP hikes (to be announced in June) are seen impacting inflation by 50bps, we may expect one more hike of 25bps in either August or October policy.

We believe the turn in rate cycle to be less steep with one or two rate hikes with inflation evolving closure to 5% in near term.

Outlook on bond market

The bond market had already priced in 75bps of tightening in next 12months, so the current 25bp hike should not affect the sentiments much, the continuation of neutral stance should comfort market participants.

In fact, at the current yields, the real issue in the bond market is not about RBI rate or of inflation either; valuations are trading cheap and attractive since January 2018.

The real issue is more to do with demand situation which has worsened since PSU banks (40% demand) are not buying which they would do naturally. The MTM hit on bonds and NPA issues are keeping them at bay.

The negative from the policy for the bond market is mark-to-market of SDLs against the current market practice of 25bps mark up for banks, this move will further put pressure on banks and lead to higher yields on SDL and corporate bonds. The spreads on SDL and corporate bonds could widen by 10-15bps from current 60bps.

On OMO front, bond market didn’t get clear guidance from RBI, so the current elevated yields will continue till PSU banks buy aggressively or RBI conducts OMO purchases to inject durable liquidity. 10y bond should trade in the range of 7.80-8.10 till then.

The RBI is said to increase the liquidity coverage ratio (LCR) carve out from Statutory liquidity ratio (SLR) to 13% from 11%, which will relieve some pressure on banks to raise short-term deposits, and the move will lead drop in short-term rates which had spiked since last two months.

(Disclaimer: The author is CFA, Fund Manager – Debt, Kotak Mahindra Life Insurance Limited. The views and investment tips expressed by investment experts on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions)