Second Hike with Neutral Stance

Transcription

1 Second Hike with Neutral Stance RBI hiked the key policy rate by 25 bps to 6.50%, while retaining the neutral stance of monetary policy. This is second consecutive hike since June Highlight of the policy was its neutral tone, while revising marginally upward the inflation outlook for 2H FY18. While the RBI is growing confident about the economic growth (by retaining June projections), it has raised concerns about impact of trade tensions on global growth and thereby on India s exports. Going forward, we expect the RBI to hike by 25 bps in 4Q FY19, unless the macro-indicators (domestic and/or global) deteriorate. Trends in Key Policy Rates and Benchmark G-sec Movement Our View: Today, the RBI hiked the key policy rate on high MSP price revisions, elevated crude oil prices, rising core inflation and rising household inflation expectations (See Annexure on last page). Reasons for rate hike: Higher than average increase in MSP prices - to have direct impact on food inflation and second round effect on headline print. Elevated crude oil prices. Broad-based and significant rise in core inflation over last couple of months indicates greater pass-through of rising input costs and improving demand conditions.

2 Rising household inflation expectations. Fiscal slippages by Centre &/or State governments. Staggered impact of HRA revision by the State governments. However, normal monsoon and cut in GST rates on several goods & services will have moderating effect on inflation. RBI has projected headline CPI to be ~4.7% y/y in 1H FY19 (June policy: 4.8%-4.9% y/y), 4.8% y/y in 2H (Jun policy: 4.7%) and 5% in 1Q FY20, with risk evenly balanced (as against upside risks in June policy). Reasons for Neutral Stance: Volatility in oil prices (Geopolitical tensions, supply disruptions might lead to increase in prices, while rise in trade protectionism can impact global growth and thereby impact adversely oil demand). Volatility in global financial markets imparts uncertainty to inflation outlook. Rising trade tensions to impact short term and long term global growth and thereby Indian growth through trade route. RBI's Macro Outlook Macro - Variables 1H FY19 2H FY19 1Q FY20 Risks Inflation Growth 4.7% y/y (Jun Policy : 4.8%-4.9%) 7.5%-7.6% y/y (Jun Policy : 7.5%-7.6%) 4.8% y/y (Jun Policy : 4.7%) 7.3%-7.4% y/y (Jun policy : 7.3%-7.4%) 5.0% y/y 7.5% y/y Upside : Elevated crude oil prices, higher than average increase in MSP prices, staggered impact of HRA revisions by various state governments, rise in households' inflation expectations, volatility in global financial markets, Fiscal slippage by Centre &/or State Downside levels : Normal and well-distrubuted monsoon, Cut in GST rates for several goods and services,lower oil prices due to trade tensions Upside : Closing output gap, robust domestic demand (especially rural), Robust global growth, Revival of investment activity Downside : Geo-political risks, elevated oil prices, global financial market volatility, rise in trade protectionism

3 Domestic Economic Growth: RBI has retained for FY19 economic growth projections (at June 2018 levels). Reasons : o Robust rural demand : Aided by Normal monsoon & increase in MSP o Firm investment activity : driven by increased FDI flows and buoyant capital market conditions o Robust manufacturing sector activity Global Growth: Current global economic growth is robust. However rising trade tensions raise the risks to near-term and long term global growth outlook. Market Reaction: Neutral rate hike was accompanied by dovish forward guidance and hence the rate hike impact was negated due to value buying at current high absolute yields. Also, market positioning was extremely light going into the policy, with excessive cautiousness built in the prices. As a result, the bond market reaction to the rate hike was extremely positive. After an initial knee jerk spike to ~7.83%, the 10yr G-Sec yields dropped sharply and closed the day at ~7.70%. The spread between the Repo rate and the 10yr G-Sec yields now stands at ~120 bps compared to ~175bps seen after the hike at the previous policy. We expect the term premia to further come down and trade around ~ bps going ahead, with expectations of series of OMOs and fewer rate hikes. Market View: The policy delivered a neutral rate hike while clearly highlighting Balanced Risks to Inflation & Growth going ahead. The inflation projections till Q1 FY20 do not indicate excessive hawkishness and signifies balanced risks to inflation projections. We have communicated time and again in our previous notes that the higher yields were a matter of technical reasons (demand supply) and not fundamental driven (rate hike fears). Given the Neutral tone of the policy today, the bar for future rate hike is high currently. The RBI clearly defended a Neutral stance highlighting balanced risks to future Inflation & Growth. From a markets perspective, stability will continue - as evident in past one month. The demand supply issue is clearly addressed by the Finance Ministry in terms of auction calendar, while the RBI has done its part to allow spreading Banks MTM losses over next few quarters. Thus, it is just a matter of time, when investors see relative value in bond yields visà-vis Cash. The underlying term premia (10yr G-Sec yields Repo Rate) in bond market have corrected from its recent historic highs; although it remains high compared to the long period average. The state of the underlying economy & macro fundamentals doesn t warrant such pessimism in bond yields. Confidence is returning to the market and with the few weekly auctions being absorbed by investor appetite, we might see further cooling of yields.

4 Market Yields and liquidity have already tightened in anticipation of aggressive rate hikes. There is excess fear pricing in the market yields. It s just a question of time whether the underlying economy will remain supportive of the tightened financial conditions or the Rate markets will have to readjust itself to the nascent growth recovery. Another positive factor for the yield curve will be the continuation of OMO purchases in response to tight system liquidity. RBI has conducted 3 OMOs in last three months and we expect it to continue with one OMO Purchase per month till September and two OMOs per month from October onwards, adding to ~1,00,000 1,25,000 crs of OMO purchases for FY Our base case remains that of a prolonged pause in interest rates with possible rate action at the fag end of FY Carry with a neutral duration construct could be a suitable portfolio strategy in near to medium term. We will focus on Steepner + Spread play in terms of Core portfolio construct. On the yield curve, the 3-7 yr G-sec rates & 2-5 yr corporate bond rates are pricing in rate hikes and are more than compensating investors for it. There is significant protection build up in the current prices. Thus, we would run this segment as our Core portfolio while longer duration would be tactically added to the portfolio. The main risk to our view is from external factors like sharp rise in USTs, US Dollar strengthening and continuous rise in Crude Oil prices. We also expect bond yields to remain range bound from near term (3-6 months) perspective as market starts pricing in a prolonged pause on policy rate action & OMOs to take care of demand supply mismatches. Value buying shall emerge on every uptick in yields as spreads with respect to Repo rate are as high as ~ bps for a 2 3 year AAA corporate bonds & ~ bps for 10yr G-Secs.

5 Annexure : What has changed since June Policy Rising Inflation Rise in Household inflation Expectations 12 Trends in Headline & Core Inflation (% y/y) RBI's Trajectory Headline CPI Core Inflation (Excl, Food, Pan,Fuel & Light Group) Upward revision in inflation forecast by Professionals Improvement in consumer confidence, but marginal decline on future prospects Source: RBI, RMF Internal Research, Bloomberg

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