Written by Dhawal Dalal
In today’s meeting, the Monetary Policy Committee (MPC) has kept the basic policy rate unchanged – repo rate at 4% and reverse repo rate at 3.35%. However, the central bank has introduced a fixed deposit facility (SDF) at an interest rate of 3.75% – an additional tool for absorbing liquidity and has maintained its favorable policy while focusing on housing withdrawals in view of high inflation levels. In addition, the MPC reduced GDP growth to 7.2% and raised the inflation forecast for FY 2022-23 to 5.7%.
As expected, the MPC has set the ball rolling on a gradual exit from its post-epidemic simple monetary policy, changing the policy stance to “tolerant when focusing on housing withdrawals”. This probably means that the RBI has indicated a possible increase in the policy rate in FY23 and the first increase is expected in Q2FY23.
Although the MPC has decided to keep all policy rates as expected, the RBI has narrowed the liquidity corridor to 50 basis points as follows and returned to the pre-epidemic liquidity management framework;
1. RBI has introduced SDF at 3.75% pa (which will help RBI to lend surplus liquidity without any collateral). This will create the lower boundary of the liquidation corridor.
2. The repo rate remains unchanged at 4%.
3. MSF (the rate at which banks can borrow from RBI without any collateral) is kept at 4.25%, or Repo + 25 bp. This will create the upper boundary of the liquidity corridor.
The RBI will continue to manage liquidity through a combination of variable rate reverse repo (VRRR) auctions to absorb surplus liquidity and inject liquidity through the repo rate. Although the reverse repo rate was kept unchanged at 3.35%, we believe it was redundant with the introduction of SDF and ongoing VRRR auctions.
In addition, the MPC has created notes of instability in the global economy as a result of tectonic changes, the ongoing geopolitical crisis, the imposition of sanctions and products essential to the Indian economy. The RBI has further observed that a sustained rise in crude oil prices could derail India’s economic growth and disrupt the outlook for inflation. This has persuaded the RBI to prioritize inflation over economic growth. This is a change from their previous position to focus on economic growth. The RBI governor did not mention possible policy normalization by the FOMC and their impact on India.
As a result, the RBI has reduced India’s FY23 GDP growth from 7.8% in February 2022 to 7.2% in April 2022. If the average crude oil is above $ 100 per barrel, there is a downside risk to this forecast.
The sharp rise in commodity and energy prices has forced the RBI to revise its FY23 average inflation forecast from 4.5% to 5.7%, with the reverse risk of this forecast. This is one of the sharp upward corrections in inflation by the RBI in just two months. That said, market participants feel that the RBI’s Q2FY23 inflation forecast is down.
The tone of the RBI governor was one of cautious optimism. He observed that “the sky may be covered with clouds but we will use all our strength, determination and resources so that the light of the sun can illuminate the future of India …”. He further pointed out that the RBI was not hostage to any rule book and no action was out of the table when time was needed to secure the economy. The governor refrained from mentioning the RBI’s direct support for borrowing the FY23 GOI through the purchase of OMO bonds, such as FY22.
What does this mean for the bond market?
The yield on IGB bonds has risen 10 to 15 basis points across the curve after the RBI signaled a possible rate hike in the future. Benchmark 10Y IGB yields have crossed the 7% level for the first time since May 2019 as market participants prepare for the upcoming supply of bonds in a low demand-supply dynamics.
We expect that the IGB yield curve will remain steep with the short-end remaining anchored at the repo rate while the mid-end and long-end of the curve are being affected by supply pressures 2-, 5-, 7-, 10-, 14. -, 30- and 40-year benchmark bonds.
Bond market participants expect that, in our view, the RBI will intervene to ensure orderly evolution of the yield curve. Being an investor in the bond market is going to be difficult when monetary policy position is becoming normal, and bond yields are on uptrend.
What should investors do?
Bond investors should be prepared for low single-digit returns like CY21 from the bond market in CY22. That said, we expect the bond yield to be the highest at H1FY23 ৷ This, in our view, will allow investors to lock in higher rates for long-term fixed income allocations through mature bond ETF / Bond Index funds in the 5-10Y segment. There is a change in the air.
(Dhawal Broker is the CIO-Fixed Income of Edelweiss MF. The opinions expressed are the author’s own. Please consult your financial advisor before investing.)