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RBI Monetary Policy Update: Rate Cut Cycle Likely Coming To An End…

Jun 7, 2016



The Reserve Bank of India (RBI) kept the policy rate unchanged at 6.50%, in line with our expectations. While the RBI signalled to stay “accommodative” in its policy stance, it has also flagged “an upward bias” to the projected inflation trajectory.

The RBI reiterated its stance on revised liquidity framework announced in the previous policy to ensure effective transmission, keeping overnight/ short term rates closer to policy rates while maintaining durable liquidity supply. On the growth front, while conditions are improving gradually domestically, the appetite for fresh private investment is still subdued due to financial stress. The growth projection for 2016-17 has been retained at 7.6% with risks evenly balanced in this policy review.

Analysis and Implications

The tone of the policy sounded little cautious with considerable uncertainty about inflation outlook. The factors contributing to this uncertainty are – firming international commodity prices, particularly of crude oil; the implementation of the 7th Central Pay Commission awards; the upturn in inflation expectations of households and of corporates; and the stickiness in inflation excluding food and fuel.

There is lack of clarity around implementation of 7th Central Pay Commission which in turn could have substantial impact on wages, housing and the overall consumer price inflation, when implemented. Usually, such implementation would also be followed by adoption of revised state pay commissions and PSU pay scales adding further upside risks to inflation over medium term.

Since, the current projections by RBI on inflation does not factor pay commission impact, we feel that retail inflation is unlikely to fall below baseline projection over medium term. And hence RBI will have limited room to cut policy rates over the course of this year even if we have a good monsoon. While the weather office has predicted above-normal annual monsoon rains at 106% of the long-period average this year, its actual progress and distribution still need to be seen over the course of next few months.

To sum up, we feel that we are nearing the rate cut cycle and expect at most 25 bps rate cut over the course of this year depending on three key variables – the forthcoming monsoon distribution, softer commodity prices especially crude oil and timing regarding the implementation of 7th pay commission.

Market Impact and outlook

The benchmark 10-year bond slipped to Rs. 100.70, yielding 7.48%, against its previous close at 100.77. The long end bonds have stayed largely range bound since the start of fiscal year, as the negative impact of higher inflation was offset by the RBI’s active open market bond purchases. In spite of having relative favourable supply dynamics for first half, the yield has still hardened a bit amid fears of Fed hike, little scope for immediate RBI easing and lack of buying support from banks.

We continue to believe that the RBI’s revised liquidity framework is the most important driver in the current context for yields to rally across the yield curve. However, the demand supply dynamics would turn unfavourable for long end bonds as OMO’s slow down and hence expect short end to rally more relative to long end.

We continue to look out for selective offerings of preference shares and moderate credit funds with a blended rating of AA and YTM’s of around 10%.