Investors shouldn’t read too much into repo rate cut
(The views expressed in this column are the author’s own and do not represent those of Reuters)
The last time the Reserve Bank of India (RBI) surprised the markets was when it announced a 75 bps cut in cash reserve ration (CRR) days before its mid-quarter review of monetary policy on March 15. It did so again in its annual monetary policy meeting on April 17, with a 50 bps repo rate cut when the markets were either expecting no rate cut or a 25 bps rate cut at best.
Why did the RBI cut the repo rate by 50 bps, amid growth showing signs of a recovery and the general belief that the worst in industrial growth was already behind us; when food inflation had started rising and with all the suppressed inflation in retail fuel, coal, power and fertiliser prices?
Did it give in to moral persuasion from the government and the industry? Or was it because cutting rates later in the year would have been difficult, if not impossible? As if to mock the rate cut, consumer price inflation for March came in at 9.5 pct the very next day.
As per media reports on April 19, the Commission for Agricultural Costs and Prices (CACP) recommended a hike of 15-40 pct in the minimum support price (MSP) of various kharif crops during FY13. Though these are just recommendations, historically, the actual hike in MSP has almost matched the recommendations. This is again likely to add to food inflation. With the current account deficit likely at 4 pct of GDP in FY12 putting further pressure on domestic currency and the consequent need for overseas inflows to finance the same, a rate cut was the last thing that should have been done.
Also, the uncertainty relating to monsoons, spike in food inflation after the transitional decline in Dec and Jan 2012 and the impending retail fuel price hikes, all create doubts over the continuance of the trend in the foreseeable future.
The RBI Governor said “the reduction in the repo rate is based on an assessment of growth having slowed below its post-crisis trend rate which, in turn, is contributing to a moderation in core inflation. However, it must be emphasised that the deviation of growth from its trend is modest. At the same time, upside risks to inflation persist. These considerations inherently limit the space for further reduction in policy rates.”
“Moreover, if subsidies are not contained as indicated in the Union Budget last month, demand pressures will persist, and will further reduce whatever space there is for monetary easing,” he said.
“Overall, from the perspective of vulnerabilities emerging from the fiscal and current account deficits, it is imperative for macroeconomic stability that administered prices of petroleum products are increased to reflect their true costs of production.”
The muted response of the markets is thus understandable in light of the above, as they doubt the sustainability of the change in policy stance. Going ahead, among other factors, further rate cuts will depend on the trends in food and core inflation, global oil prices, hike in retail fuel prices, monsoon and government action on the subsidies front. Hence, it is doubtful that we would see further cuts in the coming months, unless something really gives way.
Debt investors would thus do well not to get carried away by the rate cut and start building duration. The risk reward and outlook continues to remain in favour of the shorter end of the curve as liquidity is likely to ease further, cooling the money market and short-term rates.
Nevertheless, the 50 bps repo rate cut will have some impact on the yield curve and debt and equity markets. In bond markets, the effect of the rate cut coupled with easing liquidity, shall be more pronounced at the shorter end of the curve as supply concerns limit the impact on long-term yields. In fact, benchmark 10 year g-sec yields, three days after the rate cut, are higher than where they were immediately before the rate cut. The yield curve is likely to steepen going ahead and hence opportunity for investors lies at the shorter end of the curve and not at the longer end.
The rate cut brings in some good news for stock markets too. The 25 bps cut in base rates announced by most banks following the repo rate cut should ease the general cost of capital, albeit marginally, and probably puts a floor in place for equity markets.
On the bonds side, the status quo remains unchanged as short- term debt funds or ‘high yield accrual funds’ continue to enjoy a favourable outlook as compared to their longer term peers. Those investors fond of taking a higher risk and willing to try the longer end of the curve may do so through dynamic bond funds which have the ability to sift through maturity and actively manage duration, thereby protecting downsides pursuant to sharp up-moves in interest rates.