The Last Hike - View on the RBI Policy by Pankaj Pathak

Posted On Wednesday, Feb 08, 2023

The policy was broadly in line with the market expectations though we were expecting a pause in the rate hiking cycle this time. The RBI seems concerned about the sticky core Inflation while they are relatively more comfortable with the growth outlook.

In the last 10 months, the repo rate has been hiked by cumulative 250 basis points and the short-term money market rates have moved up by over 300 basis points. The full impact of these measures is yet to be seen. Additionally, the government has reduced the budget allocation for many of the welfare schemes along with the rural employment and farm income guarantee schemes. These measures are also disinflationary in the near term.

Based on the RBI 1 year ahead inflation estimate of 5.6%, the real repo rate is currently at 90 basis points and the real rate on a 1-year treasury bill is around 130 basis points. In our opinion, this level of real rates is adequate for the current state of economic growth and we would expect this to be the last rate hike in this cycle. We would expect the repo rate to remain at 6.50% for the remainder of 2023.

Given the 25-basis points rate hike was widely expected, there was limited impact on the bond market. Bond yields moved up 3-5 basis points after the policy announcement. We continue to expect the bond yields to go down over the medium term with improvement in external and fiscal balances and falling inflation.

Given the fact that a sizable rate hike has already been delivered and the starting yields of bonds are between 7.0%-7.5%, bond funds are likely to do better over the coming 2-3 years. Investors with a 2-3 year investment horizon and some appetite for intermittent volatility, can continue to hold or add to dynamic bond funds.

Continued reduction in the durable liquidity surplus will keep short-term rates elevated which should be positive for short-term debt fund categories like the liquid fund. We would expect further improvement in the return potential of these categories as interest accrual on short-term debt instruments has risen meaningfully. Investors with shorter holding periods and low-risk appetite should stick to Liquid funds.

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