Rupee will continue a gradual but comfortable depreciation in near future, says DSP MF's Sandeep Yadav

The rupee will continue a gradual and comfortable depreciation in near future against the dollar weighed down by factors such as volatile capital flows and trade deficit, said Sandeep Yadav, head, fixed income, DSP Mutual Fund, in an exclusive interview with Moneycontrol.

Yadav said that the worst of the rupee’s fall is behind us and any further depreciation is likely to be in an orderly fashion.

After a dramatic descent that led the Reserve Bank of India (RBI) to intervene (leading in turn to a sharp fall in forex reserves), the volatility has eased since the beginning of this month, and the rupee has been trading in a thin range.

Edited excerpts from the interview

Headline inflation has eased, but core inflation remains sticky and elevated as pointed out by RBI governor Shaktikanta Das in the post-policy press conference. How do you see core inflation placed, going forward?

The base effect will ensure that headline inflation for the next quarter will be higher than what it is today. Core inflation in India is sticky and has remained sticky globally. While the RBI mentioned that the headline inflation is expected to be lower, it has also said that it is dependent on good monsoons. On the other hand, core inflation does not have volatile supply-driven components like food. Since this inflation is more tied to growth demand rather than supply issues, we expect the slowing GDP growth to gradually lead to lower core inflation. Nonetheless, this fall will be gradual as services inflation should remain sticky due to pent-up demand.

Some expect core inflation to be in the range of 6-6.2 percent by FY23-end due to second-order impact. What’s your take?

The second-order impact on inflation has been prevalent for the past few quarters and is nothing new. On the contrary, post the initial spike of commodity prices, the impact of the second-order effects is only waning. We maintain that core inflation will only come down gradually. Nonetheless, the second-order impact will probably only reduce, unless there is a further shock on the supply side such as oil prices or food prices.

Also read: Core inflation may average 6.2-6.3% in FY23 despite CPI fall in November, say experts

Where do you see the exchange rate and forex reserves considering the volatility witnessed in the last one year?

The exchange rates have stabilised, but we believe the rupee will continue a gradual but comfortable depreciation in the near future. The trade deficit (and current account deficit) is lower than what it was, yet the levels are still high. Capital flows remain volatile and in the face of global central banks’ actions, it is unlikely that the balance of payments will be large. The RBI’s FX (foreign exchange) reserves have increased in the past few weeks, but that is largely due to valuation rather than FX inflows in India.

On the back of such data, we believe that the worst is behind us. We expect the depreciation to be orderly and within RBI’s volatility comfort zone, unless global central banks give unlikely surprises with more hawkishness than expected.

Bond yields remained volatile throughout this calendar year. Where do you see bond yields considering lower crude oil prices and easing inflation?

We are certainly in the final throes of the rate rising cycle. While there has been much discussion on easing oil prices and easing inflation, this year yields have been supported by fiscal policy rather than monetary policy. After all, the current RBI rate of 6.25 percent is higher than most economists’ projections, countering claims of inflation leading to lower yields.

However, the states have conducted significantly lower borrowing this year, which has supported the yields. This is due to (i) higher taxes and (ii) lower capex by states. While the central government also received higher taxes, these were offset by larger food and fertiliser subsidy bills.

We believe that the play between monetary and fiscal policy will continue in the next fiscal year. We believe that the government will maintain a fiscal deficit at 6 percent or below, thus maintaining the central government’s borrowing constant. The states have improved their fiscal consolidation this year and if they continue on the same path we expect next fiscal year to have lower yields.

Our expectations from monetary policy next year reinforces this view. Easing inflation, less hawkish global central banks, tapering growth and order in FX should mean that monetary policy will probably be positive on bond yields.

Also read: Year-ender: Better fundamentals to keep bond yields within range in 2023: Experts

What are your expectations from the budget, especially for the debt market?

We expect a lower fiscal deficit of around 6 percent in the budget. Of course, we are entering into an election year and there is always a worry that the government may come up with an expansionary budget. However, right now we see no reason to ring the alarm bells, especially since we have not seen expansionary budgets in previous elections.

Year 2022 saw a lot of uncertainties and challenges in equity as well as debt. Will these remain in 2023?

Every year has challenges and, let's face it, undoubtedly we will have challenges next year. Will we have the same kind of challenges that we had this year? Most probably not. This year was characterised by unusual events such as the Ukraine war, high inflation, reversal of central banks’ ultra-easy policy, etc. It is unlikely we will face such abnormal events this year.

The uncertainties this year may be more normal events such as lower growth leading to probable global recession, surprises on inflation and markets catching up with central banks’ actions—or inaction. These will keep the market on its toes. After all, the inflection points are never easy to predict and there could be multiple false starts.

Do you think debt funds will remain attractive for investors in 2023?

Yes, debt funds will certainly remain an attractive destination next year. Unlike equities, which have a long-run trend, the debt market is mean-reverting, i.e., they rise and then fall. Thus, a higher return is usually followed up by lower returns in debt.

We have had an underperformance this year in the debt market. And we have seen yields rise up, which has led to this underperformance. But we are at the higher end of the rate cycle. And we will most probably see better returns which usually follow bad returns in the debt market. So next year should remain good for debt markets.

Which funds do you suggest to investors in the debt category?

If people are unsure of the markets and want to wait till next quarter—when most risks should be behind us—then they can invest in money market or liquid funds.

However, if one does not want to time the markets, then I believe target maturity funds and short-term funds are good categories. The former may give a little more predictability, while the latter has boundaries that ensure that extreme risks are avoided.

Can we expect a further rate hike? If so, by how much? And what will be the terminal rate you are expecting?

Yes, we expect at least one more rate hike. It is unlikely that the RBI will stop rate hikes too soon, on the back of other central banks still being hawkish. The risk of ending hikes earlier exposes the currency to depreciation risk.

The repo rate should ideally peak out between 6.50 percent and 6.75 percent, assuming the rupee does not throw up any surprises.