Monetary Policy Review

For the third policy review in a row, the Reserve Bank left the key policy rates untouched in today’s policy announcement. The policy benchmark – the repo rate – remains at 6.0%. As this was largely anticipated by the markets, the yield on the benchmark 10-year government security has remained relatively unchanged at 7.6%.
Since July last year, the yield on the 10-year g-security has risen by about 120bps to 7.6%. This rise has been driven by:

• Concerns on fiscal deficit and the aftermath of the budget
• Concerns on inflation – with inflation rising to 5.2% from a historic low of 1.5% in June
• Global rate cycle change & rising yields on global government bonds
• Rise in price of oil and other commodities (chiefly industrial metals)
• Tighter liquidity conditions as the demonetization related inflows have left the system

As RBI has a flexible inflation targeting mandate (within a range of 4±2%), inflation remaining in the upper half of the band risks the RBI pre-emptively raising rates to cool the economy. Apart from the rising price of oil, the budget too has introduced new upside risks to inflation.

• Delaying the process of fiscal consolidation: the RBI estimates that a 100bps rise in deficit leads to a potential 50bps permanent rise in inflation
• Potential increases in minimum support prices for crops: as food is nearly half of the CPI basket
• Increases in import duties which directly leads to increases in prices domestically

These concerns are likely to keep RBI reasonably hawkish going forward.
So where does that leave us with yields? The risks listed above have largely been priced in by the market now. Thus without new information, we expect long bond yields to be range bound. However the lack of a negative is not a positive, and even at current levels we do not see value in long bonds given the duration risk involved.
Short rates have also sold off in recent months, with the 1-year certificate of deposit now yielding about 7.5% (compared to 6.5% in November). The entire short end of the curve (1-5 years) now appears to have “overpriced” the risk of tight liquidity and RBI policy stance. This is a segment in which we see better value. Moreover as the broad macro economy improves, we are also seeing improvement in corporate earnings which is positive for corporate bonds – especially in the non-AAA space.
Investors with a medium term holding horizon should look to short and medium term funds, while those with a short-term holding period should consider liquid and ultra-short funds.

Sources of Data: RBI, Internal Analysis

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