RBI's Monetary Policy: 50bps Cut & Roadmap For Foreign Investment

Key takeaways from RBI's Monetary Policy meet today:

Our take on the move
The RBIs monetary policy was loaded with surprises, especially for the bond market. Few in the market expected a 50 bps cut in today’s policy. And it doesn’t end there, the RBIs inflation forecast of 4.8% for January-March 2017 quarter suggests further room for rate cuts in CY 2016.

The monetary policy review by also providing a 2 year road-map for foreign investment in government bonds and State Development Loans has ensured that government bonds will remain supported and banks can reduce their SLR holdings in a calibrated manner without market disruption.

Bond yields have fallen by close to 15 bps with the 10 year government bond yield trading below 7.60% and given that the overnight rate is now 6.75%, we would expect the yield of bondsto be on the lower end due to attractive term spreads and potential demand from foreigners.

What triggered the 50 bps move?
We expected a 25 bps cut in this review to leave the Repo rate at 7.0% and then pushed out the next two possible rate cuts beyond April 2016. Our view was based on the premise that the January 2016 CPI inflation target of 6% will be met comfortably.RBI would then move its inflation target lower to 5.0% by January 2017. For the Repo rate to move to 6.5%; it would require CPI inflation to average 5.0%, thereby maintaining the 1.5% Real Repo rate spread.

So the RBI has moved its inflation target to 5.0% January 2017; but

This has allowed them to 'front-load' some accommodation and hence we have seen a 50 bps cut. The thing to note is many economists had suggested that the 'Terminal Repo' (final repo rate for this rate cut cycle) would be 7.0%. But in just 9 months in this rate cutting cycle, the Repo rate stands lower by 1.25% at 6.75%. That just shows the extent of dis-inflation seen in the Indian and global economy in 2014/15.

Foreigners get a larger play with certainty as they can now invest INR1.2 trillion by March 2018. They would also be able to invest around INR500 billion by March 2018 in state government papers.

This is a significant move and allows foreign investors a certain and greater play in the Indian bond markets. Given that India currently remains an attractive destination amongst its Emerging Market (EM) peers and that global investors are significantly under-invested in Indian fixed income this will support G sec yields to go down.

Guidance
With this 50 bps move; we expect further rate moves only post April 2016. By then, the fiscal policy for FY 17 would be clear and the initial monsoon forecasts would have been released. If the fiscal policy is favorable and one which provides comfort to meet the 5% January 2017 target, we should expect a further 50 bps rate cut in CY 2016.

From now the 1 year T-bill rate is the benchmark for calculating real interest rates, instead of the overnight Repo rate. In easy liquidity conditions, the 1 year T-Bill generally trades around 25 bps spread over Repo.

One major reason for INR stability has been the combination of the reduction in India's inflation differential with the developed world and the emergence of positive Real interest rates thus reducing the INR risk premium.

All of the above suggests to us that Indian fixed income continues to remain attractive and investors should remain invested and/or increase their allocations.

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