If the realized inflation for next year is closer to the expectations policy makers then won’t be in a hurry to hike interest rates as real rates will be around 1.5% which is reasonable to support economic growth.
As was widely expected, Monetary Policy Committee (MPC) maintained status quo on interest rates in its first bi-monthly policy for the year. On the positive side, MPC reduced its inflation expectations for the full year FY19 to 4.65% from 4.95% taking comfort from lower food prices and expectations of normal monsoon. These expectations also include impact of HRA hikes over the period. The reduction in the inflation expectations has given the dovish tone to the statement which will cheer the bond markets in the near term.
On inflation front, MPC believes there are several uncertainties around baseline assumptions especially due to formula for Minimum Support Prices (MSP), which is yet to be announced, HRA revision impact undertaken by state governments and due to possible fiscal slippage. Market participants believe the worst case impact of MSP hikes on inflation to be in the range of 30-50 bps.
MPC believes growth will bounce back to 7.4% in FY 2019 from 6.6% on the back of revival in investment demand however considers potential trade wars to be threat to the outlook. MPC has also acknowledged that long-term growth potential could be higher given structural reforms initiated in recent past; if yes; the higher potential growth could lead to slower closing of output gap and help monetary policy to remain neutral for longer time.
If the realized inflation for next year is closer to the expectations policy makers then won’t be in a hurry to hike interest rates as real rates will be around 1.5% which is reasonable to support economic growth. However they will be watchful of policy moves by major central banks and movement in crude oil prices.
Outlook on Bond Market
Bond market has seen the worst period of reversal of yields and volatility in past decade or so. Yields first moved up more than 100 bps since August 2017 till March 2018, 10 year benchmark bond shoot up to 7.82% from lows of 6.70%, the up move was attributed to following factors:• Extra borrowing announcement of Rs 50000 crore (which was later cancelled sighting higher yields).
• Brent oil moving up from $50 to $70.
• Weakening risk appetite of banks to buy bonds due to mark-to-market losses on non HTM portfolios.
The reversal in yields started in March, as inflation printed 50 bps lower than RBI’s expectations, and government’s announcement of borrowing calendar with Rs 50000 crore lower amount; lower first half allocations & lesser duration in supply. Finally RBI also allowed banks to spread losses on bond portfolios over four quarters.
Today’s dovish policy will ease yields significantly, 10 year benchmark bond yield has already dropped to 7.12% from 7.30% and we see it trading in the range of 7.00%-7.30% in the near term. Further, fillip to bond market may come from hike in FPI limits by RBI. So in near term, all these developments should bring back banks risk appetite for bonds, putting less pressure on overall market interest rates including lending rates in the economy.The writer is Fund Manager – Debt at Kotak Mahindra Life InsuranceYou can now invest in mutual funds with moneycontrol. Download moneycontrol transact app. A dedicated app to explore, research and buy mutual funds.