RBI policy review: Feel good factor continues, but time for caution

The RBI Monetary Policy Committee (MPC) presented the first bimonthly monetary policy statement for 2018‐19 and it was expected to be a routine policy review, with no change in policy rates. But there was a positive surprise. Inflation projection for the financial year, 2018-19, was toned down from what was estimated earlier. This has a positive impact on rate setting, since lower the inflation, lower the reason for hike in interest rates. Earlier, in the previous review on 7 February 2018, the RBI had given an inflation outlook of 5.1% ‐5.6% in first half i.e. April‐Sep 2018 and 4.5% ‐ 4.6% in second half i.e. Oct 2018 ‐ Mar 2019. In this review, inflation projection has been given as 4.7% ‐ 5.1% in first half and 4.4% in second half.

Market Movement

The feel good factor in the market continues. The first positive news was the ‘accommodation’ from the government in the form of lower borrowing in the first half i.e. Apr – Sep 2018. The lower borrowing quantum and the spacing out of the maturities to lower and longer brackets rather than the most issued 10 to 15 year bracket, improved sentiments significantly. Then came the ‘accommodation’ from the RBI in the form of allowing marked-to-market losses of banks to be set-off over four quarters. This is an invitation to bring sulking PSU banks back to the government securities market, since earlier banks were denied this request. And then this policy review. No threat of hiking interest rates, rather a moderation of inflation outlook.

Market reaction, in terms of yield level, has been decisively positive. At the peak of negative sentiments, in March 2018, the 10-year benchmark yield had touched 7.78%. Today, the 10-year yield is less than 7.2%.

View on Market

In an earlier article, dated 5 March ’18, we had discussed that it is worth taking a bet in long bonds or long term bond funds, in a staggered manner, as yields were at elevated levels, approx. 7.7% for 10-year benchmark. However, the rally has happened since then, and from the current levels, approx. 7.2% for 10-year, scope for further rally is limited.

The policy stance of the RBI Monetary Policy Committee (MPC) is neutral, i.e. they would take policy rate action only if there is compelling reason either to hike or reduce rates. That stance remains in this review as well. The only marginal change in this review is that instead of sounding hawkish (tilted towards rate hikes) as in the previous few reviews, the MPC did not ring any alarm bell.

There are enough reasons for the RBI to not hike interest rates in the near to medium term. However, with uncertainties on inflation like crude oil prices, higher Minimum Support Price (MSP) for crops, etc. the MPC will remain vigilant. To be sure, the policy rate easing cycle is over. Net-net, we are not expecting any sustained reduction in yield levels on bonds.

Takeaway for investors

In this backdrop that we are not expecting any long-term easing of interest rates, the advisable path for investors is to remain conservative on the play on interest rates. That is, to invest in short to medium maturity bond funds, rather than long maturity funds, as there is no special charm at this level to play for the last bit of down-tick in yield levels in the market. Any down-tick in yield levels in the market from now on, if it happens, would be driven by a correction of significant up-tick that took place earlier. For direct exposure to bonds i.e. not through the mutual fund route, preference should be for hold-to-maturity, where the investor can ride through any market volatility before maturity. Put it simply, buy if you can stomach volatility and hold till maturity.

In the past few months, some Banks have marginally raised their deposit and/or MCLR i.e. lending rates. This was not about any signal from the RBI but the fact that system liquidity is not surplus anymore, which was the case one year ago. Depending on banking system liquidity, some Banks may tinker either way with their deposit or lending rates, but broadly, interest rates are expected to be range-bound in the near to medium term.