RBI appears to be cautious on the inflation front

RBI appears to be cautious on the inflation front

August 06, 2014 11:12 IST | India Infoline News Service
We believe that the RBI’s Monetary Policy bias was “neutral” in Tuesday’s Policy Statement although the tone appeared to be a bit hawkish than the June 3, 2014 Policy Statement.
Today’s SLR reduction by 50 basis points is a repeat of the RBI’s measure announced in the previous Policy on June 3, 2014. However, a reduction of 50 basis points in Banks’ HTM category has surprised a section of market participants. The RBI has categorized these reductions as “resource mobilizing measures” for the private sector as and when economic conditions may require credit demand.

The RBI has also clarified during their interaction with media after the Policy Statement that the primary factor for SLR reduction was the government’s fiscal space while the secondary factor was the banking system’s liquidity needs. Based on that, we believe that more reductions in both SLR and HTM category could be possible over the next few monetary policy announcements.
The RBI also appears to be cautious on the inflation front. While the RBI has acknowledged that the recent decline in consumer price was due to both, strong base effect as well as steady deceleration in the non-food non-fuel component, the RBI feels that inflationary pressures are down but not out.
The RBI is worried that there could be an upside risk to its consumer price inflation target of 8% by Jan 2015 and 6% by Jan 2016. Market participants have attributed this statement as a departure from the statement in its previous policy statement, where it had alluded to the possibility of a Repo Rate cut in case of higher-than-expected decline in retail inflation, adjusted for the base effect.
During the RBI’s interaction with media after the Policy announcement, Governor Rajan acknowledged the RBI’s pro-growth approach and stated that the RBI would not want to keep interest rates higher any longer than necessary. At the same time he stressed the RBI’s strong belief that growth would be better served in a stable non-inflationary environment.
Based on this, we reiterate our view of a status quo on Policy Rates in 2014 and expect the RBI to likely announce the first reduction in the Repo Rate in Q1 of 2015 only, after a sustained decline in retail inflation.
Bond Market’s Reaction:
Government bond prices declined in the aftermath of a reduction in SLR and HTM category as market participants were surprised with the twin cuts and the RBI’s mildly hawkish tone.
The new 10Y government bond yield hardened to 8.59% from around 8.50% at the beginning of the day, while the old 10Y government bond yield hardened by 8 basis points to 8.81%. We expect bond market sentiment to remain fragile in the run-up to the scheduled auction on Friday, August 8, 2014. We expect government bond yields to remain range-bound with an upward bias in the near-term in the absence of any positive near-term catalysts. Recent change in the auction method from uniform price to multiple price may also weigh on sentiment.
Having said that, we believe there is value in government bonds maturing between 5 & 10 years. From a technical perspective, the new 10Y government bond yield is trading at the upper band of its trading range of 8.55-8.60%.
What should investors do?
We advise investors to start allocating money to open-ended income funds in a gradual manner with an investment horizon of at least 12 to 24 months. We also believe that a prudent mix of government bonds and corporate bonds may have the potential to generate better risk-adjusted returns than a single asset strategy over a 12 to 24-month investment horizon.
The Indian government bond yield curve is relatively flat with the 1Y T-Bill trading at around 8.65%, new 10Y trading at around 8.59% and the longest 29Y government bond trading at around 8.80%. We expect the yield curve to steepen over the next 12 to 18 months due to improvement of systemic liquidity and expectations of a rate cut. A steeper yield curve may result in relative out-performance of the 5-10Y segment of the government bond yield curve.
We also prefer corporate bonds maturing between 2Y and 5Y. We expect some normalization of yields for this segment amid an increase in the primary issuance and demand-supply dynamics. However, we expect this segment to relatively outperform on a risk-adjusted basis over the next 12 to 18 months, amid steepening of the yield curve and tight credit spreads.

Dhawal Dalal, Head-Fixed Income, DSP BlackRock Mutual Fund 

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