RBI plays catch-up in an off-cycle meet: IIFL Capital Services

5 May 2022 , 11:32 AM

In a surprise off-cycle policy announcement, the RBI MPC announced that:

1. Repo rate will be increased by 40bps, from 4% to 4.4%
2. The cash reserve ratio (CRR) will be increased by 50bps, from 4% to 4.5% which will reduce system liquidity by Rs0.87 trillion (approx. 11% of system liquidity that the RBI is absorbing through various deposit facilities)
3. Status quo on policy stance with focus on withdrawal of accommodation

There was no change to the estimates of inflation and growth for the rest of the year. The overall tone of the policy was marked by acknowledgement of the heightened risk of inflation, and the need for reversing the accommodative policy stance set in place two years ago when COVID-19 struck.

As the LAF corridor was locked via the introduction of the SDF in the previous MPC meet, at +/-25bps around the repo rate, all three rates will move up by 40bps, so the new SDF rate would be 4.15%, and the new MSF (marginal standing facility) rate 4.65%. The reverse repo thus remains at 3.35% and even more disconnected than ever from the rest of the rate structure. Market reaction was swift — Nifty was down by 2.3% compared with being flat before the announcement; 10-year yields were up 25bps to 7.37% and the INR was slightly up vs the USD.

While a tightening move down the line had been long anticipated, analysts at IIFL Capital Services feel that the surprise announcement was not related to either currency defence (INR is up vs USD), or the LIC IPO, or the US Fed’s imminent 50bps (or more) rate hike. They believe that the MPC was simply surprised by the March inflation print that came in on 15-April, at 6.95%, wherein food inflation − a factor where global supply response to rising prices may be inadequate − seemed a particular threat. Note that there were no major negative surprises in the price level of any major commodity between March and April, suggesting that the RBI should have been better prepared.
Looking ahead into the next three months, likelihood of relief on the commodity price front looks low, given the saber-rattling on both sides — i.e. between Russia and the EU — on gas and oil trade; also, inflation is likely to remain a threat. But the post-three-month scenario has some mitigating factors − China reopening post the Omicron wave within 3-4 months, supply chains normalizing (and a goods glut, as partially finished inventory gets converted into finished goods) and global growth slowing down, though neon gas shortage (Russia seems to be controlling Southern Ukraine, the main production center) and impact on chip production can be a continuing risk.
Hence for the next three months, monetary tightening led by the US Fed should continue and, thereafter at the very minimum, its balance sheet run-off at the rate of USD60 billion through non-reinvestment in US Treasuries should keep liquidity tight globally, including India (in addition to the RBI’s moves). Hence, interest rate outlook carries an upward bias.

However, on Indian long yields, there are 4 factors to consider:

1. As discussed above, inflation may see cooling off — in fact, analysts at IIFL Capital Services believe we are at peak inflation at present
2. The path to real yields normalization may be less steep in India than in the USA, which saw real yields fall by 400-500bps during the pandemic, whereas ours saw a much lower fall.
3. Government revenues have been strong (FY22 tax revenues at Rs27 trillion were equal to the projected FY23 revenue, suggesting significant potential reduction in borrowing intensity during FY23).
4. Indian government bonds may get included in Global Bond Indices; this should be a factor that keeps a lid on rates.

To sum up, liquidity is getting tighter, and will remain so for the near term; and yields are headed higher, though they may not reach very worrying levels. In this scenario, private banks will prosper, as will reasonably-priced names, whereas high-priced names and housing-related sectors such as cement will underperform.