RBI maintains status quo: A year without rate changes

The rates have been left alone and the stance of monetary policy has remained unchanged (withdrawal of accommodation).
The rates have been left alone and the stance of monetary policy has remained unchanged (withdrawal of accommodation).

Summary

  • RBI now expects growth at 7% for FY25. Inflation has softened and is broadly expected to remain close to 4.5% next year

It is now exactly one year since the Reserve Bank of India last changed rates—a hike of 25 basis points to 6.5% last February. In the intervening six policy statements, nothing has changed. The rates have been left alone and the stance of monetary policy has remained unchanged (withdrawal of accommodation). The bond market has been volatile in the interim, but on a point-to-point basis, is largely unchanged with the benchmark 10-year yield a little over the 7% mark.

While the rates have remained unchanged, much has changed in the macro-economic situation. Growth has stabilized. Indeed, RBI now expects growth at 7% for FY25. Inflation has softened and is broadly expected to remain close to 4.5% next year. The softening of inflation without a deceleration in growth is a clear win for the economy. This is something that we also see in several other economies such as the US. This is the no-landing scenario which was seen as outlandish a year ago. From a central bank’s perspective, disinflation without deceleration in growth is a best-of-both-worlds outcome.

As expectations of lower inflation took hold, the bond markets moved into anticipation of rate cuts. In India, the yield curve is essentially flat with one-year treasury bills and 10-year G-Secs trading at the same levels. In the US, the yield curve has been inverted for a while. Flat or inverted yield curves only make sense if the market expects short-term rates to be much lower in the future. Stronger-than-expected growth has led to a postponement of such rate cut expectations. For a central bank, premature rate cuts may put inflation at risk of rising through overheating of the economy. RBI appears to be concerned with such an overheating. Recent policy actions targeting consumer loans and the comment that the transmission of past rate hikes have yet to be completed suggests that RBI wants to see higher rates and slower loan growth. William Martin, a former US Fed chairman, once said it was the main job of a central bank to “take away the punchbowl just as the party gets going."

For the moment if we assume rate cuts are not coming any time soon, what does that mean for investing in bonds? The implication is that the current flat yield curve may remain flat or inverted. The demand-supply dynamics for G-Secs is likely to be positive on the back of large inflow from overseas investors this year as Indian gilts are added to emerging market bond indices. There is good reason to expect RBI to not sterilize inflows. The inflows could address a large part of the liquidity needs of the system. Short-term rates may remain elevated as RBI keeps rates on hold and manages liquidity very actively. Long-term rates may outperform. A strategy to hold short-term bonds for “carry" with some allocation to long bonds—a classic bar-bell approach—could be optimal. The rise in the repo rate along with tighter liquidity conditions have pushed up the spread of corporate bonds over the equivalent G-Secs. Spreads on low rated bonds have also seen some widening. If the RBI gets its wish, the residual transmission of past rate actions into credit markets could further push bond yields up. Investors should look to build their allocation to corporate bonds/credit this year.

Last, we must consider the global context. China’s growth continues to be weak, and is in deflation. Stresses in the US commercial real estate market is threatening to impact regional banks in a possible repeat of last year’s fears. Global trade looked weak even before the recent geopolitical events, including the blockages in Red Sea. If growth weakens, we should expect central banks to start cutting rates as they have built sufficient cushion for such an eventuality. Investors should look at maintaining a reasonable duration position in their portfolios.

R Sivakumar is the head of fixed income at Axis Mutual Fund

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