An ‘Accommodative Pause’

Posted On Friday, Dec 06, 2019

The decision of the Monetary Policy Committee (MPC) to remain on hold is indeed a surprise and government bond yields have reacted with a 10-15 bps increase across the curve.

An ‘Accommodative Pause’, confusing as it sounds, is what we read this decision as; a pause in the rate cutting cycle to wait and watch for government’s budget actions, the trajectory of food prices and the monetary impact of previous rate cuts.

The MPC remains ‘accommodative as long as it is required to support growth’ which in our view it will keep interest rates low, pump the system with excess liquidity and look to reduce the interest rates further as and when feasible.

They have thus deliberately mentioned that “The MPC recognizes that there is monetary policy space for future action. However, given the evolving growth-inflation dynamics, the MPC felt it appropriate to take a pause at this juncture”.

The Governor in the press conference suggested to ‘look through’ the recent increase in food prices, but in our view the fact that they have paused and increased their short-term CPI projection, makes the scope for further rate cuts impending on headline CPI inflation falling below 4% again. Given the increase in vegetable prices, the hikes in mobile tariffs and the change in prices of LPG, we do not expect Headline CPI to come below 5% in the next few months. The MPC expects headline Consumer Price Inflation (CPI) to fall below 4% in the quarter of July – September 2020.

Since February 2019, the RBI had been prioritizing growth having already controlled inflation. The MPC has thus delivered 135 bps in rate cuts (1.35%) since February with 5 consecutive rate cuts to bring the Repo Rate down from 6.5% to 5.15%. During the same time, the GDP growth forecast of the MPC for Fiscal year 2020 has fallen from 7% to 6.1% and in today’s meeting; they have cut the growth forecast further to 5%, a good 1.5%-2% percentage points below potential. The 1 year forward headline CPI forecast has though remained below 4%. Thus based on the collapse in growth and reading the MPCs growth focus, the markets had anticipated the rate cuts to continue.

The decision to remain on hold though in the MPC was unanimous, a 6-0 vote, as against the consensus market expectations of a 25 bps rate cut. This was indeed another surprise suggesting to us that the immediate priorities seem divergent. The market expectations of rate cuts were driven by supporting the growth slowdown whereas the MPC for now seems to be according higher priority to the recent rise in food prices. India’s future monetary policy discourse thus depends on the trajectory of Onion Prices. If Onion prices reverse and follow its seasonal pattern, the headline CPI will fall back to the RBI’s target and provide scope for further rate reduction.

Market Commentators were also calling for the RBI to adopt US Federal Reserve’s policies like Quantitative Easing (buying government bonds) and Operation Twist (selling short term bonds and buying long term bonds) to improve transmission (passing on the effect of lower repo rates onto lower lending rates), but the MPC, as of now, hasn’t shed its conservatism.

Governor Das mentioned about timing the rate cuts for effectiveness and maybe they want to keep some firepower in its February meeting to revive sentiments in case the budget announcements remain insipid.

The bond market will look closely to developments on the fiscal front. With sliding GDP growth and poor sentiment in private sector, the government is in a tough spot to balance their budget. In our opinion, the government will miss its fiscal deficit target of 3.3% of GDP by 40-50 basis points.

However, at the current level of term premium with the 10 year government bond yield at 6.6% trading ~150 basis points over Repo rate of 5.15%, much of the fiscal risk is already priced in the market. On the positive side potential rate cuts and easy liquidity conditions will continue to support the bond market.

In our opinion, when fiscal uncertainty goes away, term premiums (spread between repo rate and yields on longer tenor bonds) on the long maturity bonds will likely correct. Though, we do not see a structural bull run and any such positioning is only a tactical call.

We have maintained that the best of the bond market rally may be behind us now and Investors in bond funds should keep the market risks in mind while trying to benefit from any further fall bond yields.

Investors with low risk appetite should stick to short maturity funds or Liquid Funds to avoid any sharp volatility in their portfolio value. However, while choosing such funds one should be aware of the credit risk and prefer funds which take low credit and liquidity risks.

Investors should also note that the credit crisis which began in the bond markets post IL&FS default is not over yet and investors should remain cautious and should always choose debt and liquid funds which priorities safety and liquidity over returns in the current times.

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