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'RBI may raise interest rates by 15bps in December, money market rates should remain unchanged amid liquidity overhang'

Overall, the money market rates should broadly remain unchanged until the reverse repo hike in December given the liquidity overhang. The 5/10-year yields should also remain in check, with limited upside.

August 31, 2021 / 12:09 PM IST
FMPs are expected to deliver higher returns than bank fixed deposits (FDs), but that doesn’t mean they are risk-free and the SEBI penalty in itself shows that (Image: Shutterstock)

FMPs are expected to deliver higher returns than bank fixed deposits (FDs), but that doesn’t mean they are risk-free and the SEBI penalty in itself shows that (Image: Shutterstock)

The interest rates in India across all markets (money markets, Gsec, SDL and Corporate bonds) have broadly been quite stable across the curve over the last month. The fundamental factors continue to remain the same with ample liquidity, GSAP, verbal interventions with growth as focus, low credit-deposit ratios aiding natural SLR demand along with expectations that risk of the third wave will refrain the RBI from ‘pulling the rug’ anytime soon. Global factors have also aided sentiments with crude oil prices lower by 8 percent and US 10-year yields by 15bps since early July.

The recent MPC minutes reiterated the pro-growth focus even as few members remained wary on the persistence of inflation. The significant outcome from the minutes was the references made by three members on the tweaks that can be made to the existing liquidity/policy setup, although keeping stance as accommodative.

While this may provide a tinge of hawkishness, a recent interview by the Governor attempted to isolate the liquidity normalisation through the enhanced quantum of VRRR from policy tightness.

Furthermore, the recent RBI Bulletin’s reference of sacrifice ratio of 1.5-2% to GDP in order to ease inflation signals the willingness of RBI to remain accommodative for a prolonged period. Notably, RBI draws comfort from the overall moderation in average CPI inflation from 6.2 percent in FY21 to an estimated value of 5.7 percent in FY22, even if still remains closer to the upper threshold range. Moreover, the RBI may further get a respite in the near term given some overestimation of average inflation in the 2QFY22 (RBI at 5.9 percent versus our expectation of 5.6 percent).

All in, these factors are here to stay in the near term. Instead, markets are already ahead of the Central Bank in terms of a hike in operating target rates. Against this backdrop, our liquidity projections suggest a much more benign environment in 2HFY22.

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We expect the government to run down on its huge cash balance (~Rs 4.8 lakh crore currently) by increasing spending in the coming months. Further, FX related inflows to the system is also expected to continue given a reasonably decent balance of payments (we estimate ~USD 35 billion in FY22) and as RBI continues to take delivery of its forwards (even though expected to be at a slower pace than in 1H).

The currency leakage and CRR build-up are not expected to offset the incremental liquidity infusion through FX and government spending. We expect the system liquidity to further increase by Rs 1-1.5 lakh crore in 2H, without any additional GSAP.

In this context, while we see further enhancement in the VRRR in the October policy (probably of higher tenures), that would only be to absorb the additional liquidity in the coming months of 3QFY22, thereby having limited impact on the cut-off rates. Unless some permanent liquidity withdrawal measures like MSS or allowing non-bank participation in the VRRR, we expect the shorter end of the curve to continue to remain in the current range.

Meanwhile on the dated front, while we expect reduction in GSAP quantum (not entirely ruling out discontinuation) to be announced in the October policy, we do not expect yields to spike as the Centre’s public finances seem to be faring quite well signalling some windfall. The consequent impact of this would reflect in higher ability of the Centre to absorb the payout to the States for GST compensation shortfall without additional market borrowings (markets still remain wary on the Rs 840bn additional dated supply due to be paid in 2HFY22). Thus the adverse impact of lower GSAP quantum will be offset by lower expected supply.

Needless to say the evolving growth-inflation-COVID situation will be key in driving the shift from liquidity to policy normalisation process as we approach the December policy. With RBI having highlighted that reverse repo is a liquidity management tool, we continue to expect 15bps of a hike in December although the guidance may not be hawkish enough to jilt the markets as the aftermath of the pandemic will continue to weigh across select sectors for long.

Overall, the money market rates should broadly remain unchanged until the reverse repo hike in December given the liquidity overhang. The 5/10-year yields should also remain in check, with limited upside.

The author is a Senior Economist at Kotak Mahindra Bank

Disclaimer: The views and investment tips expressed by investment experts on moneycontrol.com are their own, and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
Upasna Bhardwaj is a Senior Economist at Kotak Mahindra Bank.
first published: Aug 31, 2021 12:09 pm
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