Fixed Income Investment Strategies and Market Outlook | RBI Policy Repo Rate Unchanged
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Note to fixed income investors - Feb 8, 2024

    As expected by the market, the Monetary Policy Committee (MPC) of the RBI decided to keep the policy repo rate unchanged at 6.5%, a sixth pause decision in a row. Consequently, the standing deposit facility (SDF) rate stands unchanged at 6.25% and the marginal standing facility (MSF) rate and the Bank Rate unchanged at 6.75%. The MPC also kept (with a vote of 5:1) the stance unchanged at “withdrawal of accommodation” to ensure that inflation progressively aligns with the target, while supporting growth. The decision on the policy rate wasn’t unanimous (5:1) as Professor Jayant Verma inclined towards a 25-bps cut in policy rate.

     

    Some of the key mentions in the policy statement

    1. Path of disinflation needs to be sustained and MPC will remain resolute in its commitment to aligning inflation to the target of 4% on a durable basis
    2. Reiteration of policy stance is in terms of interest rate which is the principal tool of monetary policy in the current framework. Stance of withdrawal of accommodation should be seen in the context of incomplete transmission and inflation ruling above the target of 4% and RBI’s efforts to bring it back to the target on a durable basis

    The benchmark G-sec yield has moderated from ~7.4% in October to 7.08% as of Feb 8, 2024, largely attributed to the return of FPI flows in the Indian bond market, moderating crude oil prices, expectation of policy rate cut and government’s adherence to fiscal prudence.

    Further moderation in yields would largely be dependent on quantum and timing of policy rate cuts and easing demand supply dynamics. In near-term, any major negative shock from inflation print (particularly food) due to abnormal monsoon, and unexpected further oil output cuts by OPEC, could dampen the bond market sentiment. Also, potential supply disruption due to ongoing war in the middle east could contribute to a surge in inflation.

    Having said that, headline inflation print has been undershooting RBI’s estimates lately. Also, core inflation which was extremely sticky for the last couple of years has moderated to sub 4% in Dec’23 (3.76%). This along with support from the government by being fiscally prudent should tone down local risk to the inflation number.

    Money market rates saw some moderation lately with RBI stepping in to provide adequate liquidity in the banking system by conducting VRR. With increased government spending towards the end of the financial year, government’s cash balance with RBI is expected to come down and as a result would increase banking system liquidity. RBI is constantly monitoring the liquidity situation and taking adequate two-way steps. For instance, this week RBI conducted four VRRR auction, two each on 6th and 7th Feb, to absorb surplus liquidity as after adjusting for government cash balance, the liquidity is in the surplus mode. Weighted average call rate fluctuated in the range of 6.85% to 6.35% basis evolving liquidity situation.

    Current term spread between 3-month T-bill and 10-year G-sec is at historical low levels (~5 bps) vs long-term average term spread of ~1.1%. This is expected to normalize with improving banking system liquidity. We believe, the cumulative impact of the 250-bps hike in policy rates since May 2022 is yet to be fully reflected in the economy, which typically happens with a lag. With today’s announcement of no change in policy rate and stance by RBI, markets are now expecting rate cut in Q2 of FY2025. The 10-year G-sec, in the short term, is expected to continue to trade in a range bound manner in the absence of any adverse event.

     

    Strategy for fixed income investors

    • With policy rate at the peak of the current cycle, yields offer a decent accrual and a possibility of participation in capital appreciation. Long-term yield could remain sensitive to the evolving growth-inflation dynamics. Despite this, the current medium & medium to long-term yield levels appear relatively attractive and gradual increase in debt allocation could be considered, to benefit relatively more with anticipated moderation in yields.
    • Corporate bond spreads have widened lately, although AAA spreads are still lower than the LTA amid lack of supply in the bond market. In select instances, spreads for AA and A appear attractive after adjusting for risk. Investor with an appetite for credit risk could start evaluating select high yield strategies.

    We continue to maintain neutral stance on overall debt allocation across risk profiles. Debt as a part of the overall asset allocation mix helps to fundamentally diversify the portfolio. This can be achieved by considering select debt and hybrid solutions.

     

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