By: Punam Sharma
The RBI cut repo rate by 25 bps to 7.50% today as was consensus market expectation. Reverse repo and MSF rates will correspondingly move down in tandem. CRR has been left unchanged. More importantly, however, the tone of the policy is fairly neutral with the Governor assessing headroom for further monetary easing ‘quite limited’. This has caused bonds to sell off with the 10 year government bond dealing at 7.90% at the time of writing.
The concerns exhibited by the RBI remain quite consistent with the stance since January. Even though ‘core’ WPI inflation has fallen to below 4%, the headline is quite sticky at a level ‘which is not conducive for sustained economic growth’. This stickiness is due to high food inflation and pass through of administered prices. CPI has been climbing thereby driving a wedge with WPI and further complicating the task of monetary management through adverse implications for inflation expectations.
Growth is a big concern and the foremost challenge is to revive investments. However, the RBI notes that a ‘competitive interest rate is necessary for this, but not sufficient’. Instead, the bulk of the effort in this regard has to be undertaken by the government in form of bridging the supply constraints, staying course on fiscal consolidation, both in terms of quantity and quality, and improving governance.
We have been saying for some time that this is an extra-ordinary economic cycle. This is most clear in the fact that a decade low GDP growth is not mapping with a host of macro-economic factors including inflation, current account deficit and banks’ credit to deposit ratio (please refer our early January note on macro triggers for 2013 for details). This state of affairs is predominantly owing to an extra-ordinary consumption stimulus provided by the government since 2009 with little focus on creating investment capacity. The bulk of the solution also, then, has to rest with the government easing supply constraints.
Alongside, however, there is a distinct seasonality to rates that helps bond performance irrespective of rate cuts (please refer our note titled “It’s Not an Event, It’s Not Secular: It’s Somewhere in Between” dated 7th January 2013 for details). Hence, our approach to portfolio management first takes account of seasonality triggers (which can be relied upon) and then possible RBI rate cuts (which cannot be relied upon).
We had been overweight government bonds from late last year to February this year first because net supply of government bonds was favorable (and hence ‘seasonality’ was working in favor of the trade) and then on expectation of further rate cuts by RBI (we had expected 50 bps in Jan – March quarter which has been realized after today’s rate cut). However, with a new auction calendar starting from April, the seasonality trigger for government bonds will no longer work in favor over the next few months. It is due to this reason that we have shifted to being overweight front end corporate bonds (1 – 5 years) where seasonality will now work in favor as shorter end rates come off reflecting lean season on credit between April – September. Any rate cuts will only help the trade along. Having said that, we may look to re-enter government bonds once we judge that the ‘supply premium’ is getting built back into yields. Meanwhile, RBI’s guidance may cause market to remain wary of a deep rate cut in the May policy as well. This in turn may keep government bonds subdued in the near term.
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