Monetary Policy Review

The Reserve Bank of India surprised the markets by holding rates unchanged and changing its stance of monetary policy from accommodative to neutral. The benchmark overnight repo rate was left at 6.25%. Back in December, the RBI had held rates unchanged, but had signalled an accommodative stance indicating the possibility of future rate cuts.

The hawkish change in stance has come during a time when we have not seen any significant upside risk to growth or inflation, thus taking the market unawares. In response, bonds fell – with the 10-year government bond yield rising by about 25 basis points to 6.69% from 6.44% just before the policy announcement.

In the wake of demonetization of high value currency notes in November, there has been a significant drop in inflation – chiefly led by a fall in vegetable prices. Some of this is likely to be distress sales thus potentially providing some upside risk to inflation in the months to come. In addition core inflation – inflation other than in food and fuel – has continued to be sticky just below the 5% level. To RBI this suggests that the medium term outlook for inflation is higher than the 4% level it is targeting.

The impact of demonetization was judged transient from the growth perspective also. The pace of remonetization has been quick and the RBI further relaxed cash withdrawal norms from savings accounts. This in conjunction with an improving global growth outlook also argues for reduced monetary accommodation.

We have previously argued that RBI is close to the end of the rate cut cycle. Today’s neutral stance supports this view. In this context we believe that short bonds are likely to outperform long bonds going forward. Money market and short term bonds are also beneficiaries of the abundant banking system liquidity following demonetization and are relatively insulated from the risks of global rates and inflationary pressures.

The RBI’s focus on controlling inflation in the medium term provides some opportunities too. If inflation is indeed contained to 4% on a sustainable basis, yields can drop materially over the next couple of years. While rates may remain elevated in the near term, this may prove very attractive with a slightly longer term investment horizon.

In recent months we have reduced duration across our fixed income funds and we expect to further hold a lower duration stance across the portfolios.




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