Suyash Choudhary

The RBI hiked rates by 25 bps, thereby taking repo to 6.25%. The market was largely indifferent with respect to the timing of the hike, insofar that the market was already fully pricing in more than a 50 bps hike. Some of the key takeaways were as follows:
 
1. The MPC has hiked its CPI forecast to 4.6% ex – HRA in H1 (from 4.4 – 4.7% previously) and 4.7% in H2 (from 4.4% previously). Risks are still deemed to be tilted to upside. The analysis on CPI is somewhat concerning since the MPC notes a compositional shift in inflation: Core CPI ex- HRA has firmed up suggesting hardening underlying pressures. Further, prices of oil and other commodities have hardened. Alongside recent global financial market developments (likely reference to INR depreciation) has resulted in firming up of input cost pressures. On the other hand, food inflation has remained muted and the usual seasonal pick up has been delayed. One interpretation of these observations could be that the sources of inflation are moving towards stickier sources and that food prices are bound to catch up eventually with their seasonality. Indeed, the MPC notes several upside risk factors inflation including from hardening house hold inflation expectations feeding into wages and input costs, second round effects from states’ HRA revisions, and potentially from MSP revisions. As balancers the MPC notes that pass through on output prices remains muted presently, oil prices may impart ‘two-way’ risk to CPI, and that a normal and well distributed monsoon may keep food inflation benign.

 

2. The outlook on growth is fairly sanguine and earlier forecasts of 7.4% for FY 19 has been retained. Indeed, the MPC notes improvement in capacity utilization and credit off-take as continuing to support investment activity; although it does note the recent tightening in financing conditions. Global demand remains robust and is expected to support exports and investments. Finally, consumption is also expected to be strengthened further, although the effect of higher oil on disposable incomes is noted. The MPC explicitly notes that the output gap has almost closed.

 

Takeaways

 

The hike in repo rate is consistent with what we would have expected RBI to have done (please refer “Don’t Think Twice, It’s Alright: A Macro Update”, dated 11th May for details). However, there is little colour obtained from a forward guidance standpoint. We assess here whatever little can be gleaned. Thus the stance is still neutral and not switched to ‘withdrawal of accommodation’. This shows a willingness to continue to remain flexible and probably indicates that the MPC is not at a stage yet to fully commit to a tightening cycle. This could in turn be because of the heightened level of uncertainties (including global) as well as the fact that financial conditions have already tightened significantly. Thus the MPC may have feared an overkill in changing stance as well. Given our expectation that this is likely to be a shallow rate cycle, it is even possible that the stance remains neutral for the duration of it. However, whatever has been said gives little clarity on the timing of the next hike.
 

The continuation of a neutral stance re-emphasizes a neutral liquidity view as well. Dr. Acharya gave some clues into the thinking on liquidity. Thus the initial expectation of positive liquidity early in the financial year seemed to have been negated owing to higher currency in circulation and RBI’s own forex operations. This seemed to have triggered the first (and only so far) OMO bond purchase, since the RBI was anticipating headline liquidity to turn negative. While the system has turned positive now, the deputy Governor notes continued above trend expansion in currency in circulation. To that extent, he has left a near term OMO very much on the table. However, the Governor on the other hand mentioned that the target is keeping the weighted average call rate close to repo. This statement, if taken at face value, again dilutes the possible guidance on future OMOs.
 

There have been significant regulatory measures announced as well. Some of the major ones are as follows:

 
1. Liquidity coverage ratio (LCR) carve out from SLR has been increased to 13% from 11% previously. This partly addresses a long standing demand from private sector banks. As a first effect money market rates have softened somewhat.
 
2. SDL valuation at 25 bps over equivalent government bonds has been disallowed. Valuation will henceforth be on observed prices. Ceteris paribus, this should cause some widening on SDL spreads.
 
3. Banks have been allowed further dispensation on spreading mark to market losses. Now they can spread the June quarter losses as well over 4 quarters.
 
4. Starting August 2018, the ‘haircut’ formula for securities pledged under RBI LAF will change. Shorter maturity securities will invite lower haircuts. So would rated SDLs.
 
Conclusion (It’s Alright)

 

The rate hike today was almost desirable as a place holder for RBI / MPC to sound pre-emptive. This is especially so as the bond market has already done a lot of tightening. The only issue for the market possibly is that there is very little guidance here to anchor oneself on. These pertain more to timing than anything else. Thus we are happy to stick with two large theses in the current market: 1> this will be a relatively shallow rate hike cycle 2> OMOs will eventually come in size to address core liquidity. However, one is none the wiser after today on either the timing of the next OMO or that of the next rate hike.

 

Given the underlying thesis but the lack of timing certainty, there still is no case to hold long duration. Our preference remains for bonds largely at the front end (up to 5 years chiefly) where the element of rate hike pricing is the starkest and where any incremental bond demand is most likely to manifest. Even the dispensation on LAF haircuts make front end bonds more attractive on the margin. A positive trigger for market can come from FPI demand stabilizing (rupee has been stable for a month now). At any rate, we don’t expect front end rates to rise much further from here. As mentioned before, the carry embedded here compensates enough even for some further near term mark to market losses. SDL spreads will likely widen post the valuation changes notified today. We have negligible exposures to SDL / UDAY across the platform.
 
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