The Reserve Bank of India (RBI) put out a fairly dovish monetary policy today. The central bank left the benchmark repo rate and monetary policy stance unchanged – largely anticipated by the markets.
But the accompanying commentary significantly changed the outlook for rates resulting in a sharp rally in bonds (fall in yields).
The top takeaways from the policy are:
Firstly, the RBI acknowledged that its previous forecasts of inflation were way off base. Earlier in the year, the central bank projected inflation to hit the 5 percent mark by mid next year, which is well above the inflation target of 4 percent.
Today, the RBI revised its projection down to 4 percent. With inflation projected to be in line with target, the need to maintain a tightening stance of policy comes into question.
Indeed, the RBI governor Urjit Patel stated that if upside risks to inflation do not materialise, they would have to relook at the stance of policy. This means that the likelihood of a rate hike has come down and we could look at a long period of stable policy rates. In fact, if inflation undershoots even this projection, the RBI may well have to cut rates next year.
The market had expected a pause in rates, but this softening of inflation projection and statement on a potential change in stance led to a sharp rally in bonds. Bond yields fell by more than 15 basis points to 7.45 percent today. Since the peak in yields back in October, we have now seen yields drop by about 75 bps.
One basis point is a hundredth of a percentage point.
Second, the RBI made some additional commitments towards easing liquidity in the money market. The banking system has been in deficit liquidity for several months thanks to foreign exchange outflows and a rise in currency in circulation.
As a result, money market and short-term bond yields have remained elevated. The spread between yields on high quality (AAA rated) bonds and the repo rate has been at multi-year highs. Now, the RBI has stated that they will add liquidity through open market operations (OMOs) for the rest of the year in a bid to ease liquidity.
The RBI also reduced banks’ statutory liquidity ratio (SLR) to free up more bonds for banks to access liquidity. These steps will go a long way to reducing the stress on the money and bond markets.
Finally, the RBI stated that they were monitoring the situation with regard to non-bank financial companies (NBFCs) and were ready to be the lender of last resort to the sector if it became necessary.
A combination of tight money market liquidity and the defaults by IL&FS in September had resulted in non-banking financial companies (NBFCs) finding it difficult to finance themselves in the money market. This has a real effect on the economy as NBFCs on aggregate are significant players in key lending markets such as housing and auto loans, and loans to small and medium enterprises.
In the last few years as the banking system has been struggling with a non-performing loan problems, it has been these non-bank financiers who have stepped up to provide credit to the commercial sector. A squeeze on NBFCs could put economic growth at risk.
By agreeing to be on standby to be a lender of last resort, the RBI is signaling that the central bank stand behind the financial sector. This again should give confidence to the market to lend to financial companies again.
Between the steps on OMOs and NBFCs, we should see money market and bond rates also drop. The first move has been in government securities (G-Sec) as it’s the most liquid market.
Yields on the benchmark 10-year G-Sec has dropped by over 15bps today. Similarly, short-term certificate of deposit yields too have dropped by around 15 bps today.
Nevertheless, these rates remain high. One year bank certificate of deposit (CD) rates are around 8.2 percent today and the spread to the repo rate remains elevated. As the liquidity steps get delivered by RBI, we should see this spread compress and rates start to come down.
As investors in the bond market, the change in RBI’s commentary is welcome. This year we have seen two rate hikes, a hawkish change in policy stance and extremely tight liquidity conditions. As we end the year, though the outlook seems much brighter.
R Sivakumar is head - fixed income, Axis Mutual Fund.
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