Ineffective rate cut transmission - blessing in disguise!
RBI is in disappointment mode post the 29th September 50 bps rate cut. The expectation then was either rate pause or 25 bps rate cut. RBI was expected to stay in caution ahead of mid October FOMC for better clarity on FED stance on timing of start of rate hike cycle and the quantum. RBI took comfort from the then expectation by majority that FED may shift rate hike actions to 2016. The comfort was also from successive sub 5% CPI (and WPI) print in July & August, and robust FII flows fueling Rupee strength and downside pressure on Bond yields across tenors. 10Y bond yield did cover maximum 25 bps rate cut with gradual decline from 7.90-7.93% to 7.70-7.73% preparing for stability around par value. The pleasant surprise of overdose 50 bps cut brought cheer with post action 10Y bond rally into 7.45-7.50% squeezing India-US 10Y yield-spread to 5.35%. The unfortunate "twist" was here; FOMC guidance tone on mid October review was hawkish giving signal for mid December rate hike driving the US 10Y yield from 1.90-1.95% to 2.30-2.35%, which undid the FII appetite to drive 10Y bond to 7.75-7.78% and Rupee from 64.70-64.85 to 66.65-66.90. The disguise is from the fact that 1.25% rate cut transmission has turned inefficient with rate-cut ammunition have turned ineffective. The blessings is from both interest and exchange rate. The spread between India 10Y yield and Repo rate is sharply up from sub zero to 1% in 2015. The sharp decline in short term money market rates by over 1% and status-quo yields on the medium to long term tenors is win-win for "vocal borrowers" and "silent savers". The post 29th September rate cut Rupee rally from 66.40 to 64.70 is to the discomfort of RBI when USD was extending gains over major and emerging markets currencies. Rupee value at 66.65-66.90 is seen good to retain export competitiveness and attractive to FDI and Masala Bonds. A weak Rupee will also lead to FPI turning overweight on India Bonds when equity appetite is low.
What will be RBI response to the post 50 bps rate cut adverse impact on Bond yields and Rupee exchange rate? With October CPI back at over 5% against risk of unwind of tailwind support from price advantage of Brent Crude & Rupee exchange rate and worry from spiraling food prices, what is RBI outlook on inflation on the way forward?
Sustainable comfort on inflation is seen to be distant away
RBI is expected to stay in discomfort on CPI outlook. The pressure is likely to be from the risk of price stability of Brent Crude at elevated levels of $45-60 taking away the expected comfort at $35-50, Rupee under pressure at 66-69 and supply side pressure on food prices. The pipeline efforts to get India growth momentum beyond 7.5% is inflationary against low short term money market rates and higher consumption led demand over limited supplies. While stop-gap measures on supply side can provide temporary relief, RBI concerns will be on long term sustainability given the very limited bandwidth on rate post 1.25% rate cut in 2015. RBI has no space to provide comfort to stakeholders from favourable inflation expectation till end of FY16. While set long term CPI tolerance zone of 4-6% is safe, sustainability at 4-5% is in doubt for RBI to ease system liquidity from deficit to surplus. RBI will stay in caution retaining end FY16 outlook around 5.5% with slippage bias into higher end of 5-6% rather than lower end. The probability of 25 bps rate cut in Q2/2016 on sub 5% CPI print as at end of FY16 is very low at this stage. The resultant elevated 10Y bond yield at 7.65-7.90% is good to retain FPI appetite and ease pressure on Rupee exchange rate.
Need to revive investors and lenders confidence to restore India optimism
Banks and financial intermediaries are not seen to be active participants to India capacity expansion against pressure from Capital and NPAs. When the revenues is under squeeze, the comfort from buffer income from investment book is now behind. It is less said the better on the psyche of the investor community, both domestic and foreign. RBI has the critical task to improve the fire-power of Banks and non-Bank financial intermediaries, leading to better risk-reward environment for investors. Government is already working on resolutions to structural woes around Financial system, but RBI's role to make them work is critical. The track record on successful execution of reforms and measures is not good, hence the expectations from RBI to provide the necessary comfort to investors and higher risk-on bandwidth for lenders.
Measures to ring-fence India from rising US yields and speed-break its impact on financial markets
FED is seen to start the rate-hike cycle in mid-December FOMC meeting. The majority expectation is for 2-step 25 bps hike before end of FY16. RBI will be left to defend 10Y bond at 7.93% and Rupee at 68.85. The impact on India equity markets will also be adverse, not ruling out new NIFTY 2015 low below 7500. Investors will look for cues from RBI guidance to turn overweight for the short/medium term or turn light in the short term retaining appetite till better clarity.
It is non-event (before the event) on policy rates, but lots to hear on RBI's outlook on the way forward
This is one of the few occasions when an RBI policy review event has gone out of focus before the policy day. There is no case for review of 6.75% operating Repo rate or the need to tinker with CRR or SLR. RBI can't cut HTM limit when 10Y bond yield is up from 7.45% to over 7.75%. The expectation will be on either hope & confidence or caution & discomfort from RBI outlook and guidance on the way forward. Fingers crossed!
Moses Harding
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