Short term rates to soften going forward: Axis MF

RBI sent a contradictory message by increasing the repo rate by 25 bps citing the fiscal deficit & need to temper inflation expectations

September 21, 2013 10:59 IST | India Infoline News Service
The RBI's decision to increase the repo rate by 25 bps will further increase the cost of borrowing and owning home will become more costl

The RBI in its Mid-Quarter Review of Monetary Policy 2013-14 statement today kept the CRR (cash reserve ratio) unchanged at 4%, while it hiked the repo rate by 25 bps (basis points) to 7.5% and consequently the reverse repo rate stands at 6.5%.

The central bank has reduced daily CRR requirement to 95% from 99% and maintained MSF (marginal standing facility) rate to 75 bps to 9.5%.

Below are the comments of  R. Sivakumar, Head Fixed Income, Axis MF, India on RBI Mid-Quarter Monetary Policy Review.

Recently the RBI has been focused on currency stability. Since July, it has instituted a raft of measures including raising the overnight rate by 300 bps and tightening liquidity in the money market. The postponement of tapering by the US Federal Reserve and the fact that the currency has stopped depreciating has allowed the RBI to reverse some of these measures.

The RBI governor expects that the MSF spread over the repo rate would be brought down to 100 bps (200 bps currently) and the repo would become the operative rate in the overnight markets in due course.

Even as the effective overnight rate was reduced, the RBI sent a contradictory message by increasing the repo rate by 25 bps citing the fiscal deficit & need to temper inflation expectations. With regard to the growth-inflation dynamic, RBI said that “the need to anchor inflation and inflation expectations has to be set against the fragile state of the industrial sector and urban demand.” It appears that inflation has taken a higher priority over growth. There has been a substantial softening of inflation in recent months despite the currency depreciation. Nevertheless CPI inflation remains high and despite an expected kharif harvest led moderation, the RBI stressed that there was “no room for complacency” with regard to inflation.

here has been a substantial moderation of inflation whether it be CPI or WPI since last year. Indeed core WPI inflation has fallen to a multi-year low of 1.9%.
Growth too has fallen over the past several quarters. Since a peak growth of 11.4% in March 2010, we have seen GDP growth fall to 4.4% in June 2013. GDP (market prices) has fallen further to 2.4%. Both measures are at their lowest since the crisis years of 2008-09. Last year’s GDP growth was the slowest in a decade. Similarly IIP growth is at its worst since 2009. In this context, the rate hike by the Reserve Bank was completely unexpected by the market.

Bond Market Outlook & Strategy

RBI has provided a clear direction for short term rates to be headed lower. It has indicated that the MSF spread would be reduced and the repo rate would become the operational overnight rate. As a result we expect money market and short term rates to continue to soften going forward. Money market yields were broadly stable following the announcement of the policy.

At the longer end of the yield curve, bonds sold off sharply. The markets did not take kindly to the mixed policy – with a rate hike and rate cut in the same document. The benchmark 10-year government bond yield rose by nearly 40 bps to 8.57% following the announcement of the repo rate hike. At this rate, it represents close to 100 bps over the LAF repo rate – about in-line with its long term average. For the long bond yield to drop, we need to see a change in the RBI’s stance with respect to the repo rate. We believe that this will follow a moderation in growth and inflation in the months ahead. Lower price increases in food (minimum support prices) along with a good harvest will go a long way towards alleviating inflation concerns over time.

Investors with a short to medium term view should look to invest in short duration funds as yields in this segment are poised to drop in the near future. Longer duration funds would outperform once inflation begins to slow allowing the RBI to cut the repo rate.

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