Inflation down: But does that mean rates will be cut soon?

INFLATION IS DOWN

Consumer inflation printed lower at 4.25 percent in May 2023 compared to 4.7 percent the previous month. This was the fourth monthly drop in a row and is the lowest point of the last 25 months. Despite this, few experts are talking of a rate cut by the Reserve Bank of India (RBI) in the current year. However, bond market experts say that there is a scope for moderation in yields later this year, rewarding investors.

Down, but not out

In its monetary policy announcement of June 8, the RBI forecast the inflation to be at 5.1 percent for FY2023-2024, compared to 5.2 percent in its previous outlook. Though inflation is printing lower numbers, most experts are of the view that it may not fall much. The current decline is more to do with the base effect. Also, going forward, inflation may spike if El Nino fears play out and the monsoon is delayed.

“While favorable base effects will remain in play in 1HFY24, upside risks remain from monsoon-related uncertainties. We revise down our FY2023-24 headline inflation estimate to 4.9 percent from 5.1 percent earlier,” wrote Suvodeep Rakshit, Senior Economist, Kotak Institutional Equities, in his Economy Research note titled — ‘Inflation surprises on the downside in May’. “While the lower-than-expected number in May will increase markets’ expectations of an earlier-than-expected start to a rate cut cycle by the RBI, we retain our view of an extended pause,” he added.

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He is not alone. Ayushi Chaudhary, Economist, and Pranjul Bhandari, Chief Economist, India and Indonesia, at HSBC Securities and Capital Markets (India), expect inflation to average 5 percent in FY2023-24. “We do not expect any change in India’s policy repo rate in 2023. Come 2024, we forecast two repo rate cuts of 25bp over 1Q and 2Q, taking the policy repo rate to 6 percent by mid-2024,” they wrote in their research note — ‘India CPI and IP: Good gets better’.

Rates steady but bond yields to adjust

The US Federal Reserve is still fighting inflation. However, with inflation at a two-year low — the latest reading came in lower than expected — there are heightened expectations that it will hold rather than hike rates. Which way the Fed chooses to go will be known later today.

RBI may take cues from the actions and commentary of the US Federal Reserve. Most experts do not expect any change in stance in the first half of the financial year. By September, the southwest monsoon would have passed and macro-economic data about economic growth, inflation, and credit demand will give policymakers a fair idea of the big picture.

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Systemic liquidity — the excess money banks have after they are done with lending and investing each day — is in a comfortable surplus now, but may change. In the second half of the fiscal year, seasonal demand for money owing to the festive season will kick in. Also, there are state assembly elections to be held while the Lok Sabha election will come up some time after the first quarter of CY2024. This may lead to money moving out of the banking system. Bond yields keep adjusting through this period, as per the macro-economic data.

“In the second half of the financial year, there is a possibility that the RBI may need to infuse liquidity through open market operations, which should steepen the yield curve. Short-term yields are expected to fall more than long-term yields,” says Rajeev Radhakrishnan, CIO–Fixed Income, SBI Mutual Fund.

As of now, the yields on bonds maturing in one, five- and 10-years quote at 6.81 percent, 6.93 percent, and 7.02 percent, respectively. They are very close to each other. In the ideal case, the yields on shorter-term papers should be much lower than on long-term papers, making it an upward sloping curve.

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An RBI intervention if the bond yields on short-term papers come down will see investors in short-term bonds make capital gains. Yields on long-term papers, however, are influenced more by the inflation expectations of investors, and that has already corrected over the last year, when inflation expectations moderated. A further moderation may take some time.

Where to invest?

R Sivakumar, Head–Fixed Income, Axis Mutual Fund, said that the investors are more likely to benefit if they invest in short- to medium-term bonds over long-term bonds.

Though long-duration bond funds and short-duration funds have given 11.75 percent and 6.73 percent returns, respectively, in the 12 months to June 12, as per Value Research, investors should not overlook the fact that short duration funds are now in a sweet spot.

“As the yield curve is flat, investors are better off investing in short-term bonds maturing in one to three years or mutual fund schemes that invest in such papers,” said Vikram Dalal, Founder and Managing Director, Synergee Capital Services. He recommends investments in National Savings Certificates and the Senior Citizen Savings Scheme as well as RBI Floating Rate Savings Bonds, if investors are willing to forgo interim liquidity.

Ideally, while investing in debt funds, it is better to match the holding period of the investor with the duration of the debt fund to reduce the impact of interest rate risks.