Quantum View: RBI Cuts; Repo Rate Back to 6%

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) delivered its first consecutive rate cut since it was formed in October 2016. The MPC had cut the Repo rate by 25 bps (0.25%) in February 2019 and they have now cut the Repo rate by another 25 bps in its April 2019 monetary policy review.

These two 25 bps rate cuts takes the Repo Rate back to 6.0%, a level it had reached in August 2017, which was then followed by two successive rate hikes in June and August 2018 of 25 bps each. The Repo Rate thus has remained in a tight range of 6.0% - 6.5% in the last 2.5 years. But Market interest rates (bond yields), bank fixed deposits and lending rates have moved in a wider band and they are higher than the levels of 2016. This is instructive to know that RBI actions many not have similar impact on the market interest rates.

The RBI and the MPC thus should move focus on the transmission of the lower Repo rate on to getting the banks to reduce the bank lending rates, lower EMIs. Lending rates continues to remain high and the overall economy is not enjoying the benefits of the lower interest rates as seen from the Repo Rate.

There seems to be a need to add (infuse) more liquidity into the system which will allow market interest rates and lending rates to move lower. The RBI has indeed added large amounts of liquidity in the markets in the last year but we believe there needs to be further addition of liquidity to yet fully re-monetize the economy two years post demonetization (which had removed currency from circulation).

The RBI will also have to communicate to the markets in an emphatic manner that interest rates can remain low for a period of time allowing market participants certainty in their actions.

The 25 bps rate cut was as per market expectations, but 2 of the MPC members have again voted for no change. The markets were expecting a consensus (6-0) voting for a rate cut. The RBI has now reduced its inflation forecast by more than 0.5% (50 bps) over the last two policies but despite that the MPC hasn’t had consensus on rate cuts. We find this to be a bit puzzling and wonder if there are certain externalities which have not been factored in their forecast but which is worrying the MPC members. As based on their forecast, the MPC expects CPI inflation to average 3.4% in FY 2020. The Repo rate is at 6%. That gives an Average Real Repo Rate of 2.6% for the next year; well above its ideal level of 1.5%.

The MPC has indeed retained the future monetary policy stance at neutral; they rightfully seem cautious about oil prices; have assumed normal monsoon and are more sanguine about growth prospects than what the current drop in activity suggests. This along with the 4-2 voting thus raises the bar for another rate cut despite the lower inflation projection.

The bond market was priced for a 25 bps cut and for expectations of more to come, which we believe will be scaled back. The MPC meets next in June first week, by then, India would have known who has formed the next government and would have the first confirmation on the onset and likely progress of the monsoon. A non-BJP government and hazy monsoon outlook may keep the MPC on hold in June.

Bond Yields has reacted upwards reversing the gains it had posted over the last week. At 6% Repo Rate, the 10 year government bond yield at 7.25% - 7.35% remains fairly valued. But on the prospect of higher bond supply, lower potential OMO purchases and uncertainty on further rate cuts, the bond yields will continue to remain at a higher level than what is required at the current state of the economy and monetary policy stance. Add to that, the uncertainty on oil prices and on the election outcome, the trajectory of longer tenor bond yields remain uncertain and may remain volatile. This aspect will continue to impede actual transmission of rates onto the economy.

Investors in debt mutual funds should expect slightly lower returns from liquid funds as the rate cut reduces yields/accrual on short term instruments. Fixed Deposit Rates should remain range bound around the current levels; so will lending rates unless RBI takes steps to lower them. Investors in Bond Funds, as always will have to remain aware of the near term volatility in interest rates and invest only with a 2-3 year view.

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