Steady decline in short term rates against hardening long term yields
RBI delivered 3-baby steps rate cut pushing the operative Repo rate from 8% to 7.25% in H1/2015, shifting to accommodative monetary policy stance to be growth supportive backed by trend down in CPI inflation into its tolerance zone of 4-6%. RBI formula was also made known to stakeholders, to maintain 1.50-2.0% spread between CPI and operative policy rate. This sets up the need to retain Repo rate as operative policy rate till CPI come at ease at lower half of 4-6%. As a first step, RBI cut the refinance availability at Repo counter against excess SLR held by Banks. The previous 100% entitlement at overnight Repo counter is squeezed and spread over to term Repo counter. This strategy to avoid build-up of surplus system liquidity retained Call money rate between Repo and MSF rate, currently at 7.25-8.25% with intent to resist trend down in Call money rate into LAF corridor, now at 6.25-7.25% while CPI stays at 5-6%.
The impact of rate cut was surprise to many; while short term Treasury Bill yield trended down from 8.10-8.35% to 7.35-7.60%, previous 10Y benchmark 8.40% 2024 yield spiked up from 7.50-7.65% to 8.0-8.15%. In the process, inverted yield curve got shifted into upward sloping curve. It served the desired purpose of bringing the lending rates down (through lower short term money market rates) while keeping long term yields (at elevated level) attractive to foreign investors to retain them from staying invested in India. What next?
FED rate hike versus RBI rate pause in H2/2015
FED stance is now clear for shift into rate hike cycle on or before Q4/2015, so is RBI signalling no rate cut in 2015 with January 2016 CPI outlook at 6%. So, Repo to stay as operative policy rate through rest of 2015 despite infusion of liquidity through $ purchases. RBI has already shown the way to sterilise the excess liquidity through OMO bond sales. While there is good comfort on easy short term money market rates, demand-supply mismatch will exert upside risk on long term Gilt yields. Banks are already holding huge excess SLR at 28-30% of NDTL against mandatory 22%. The aggregate of FY16 bond auctions and OMO sales may not be met with desired demand appetite. However, higher "carry" at 75 bps extend solid support for 10Y bond at 7.90-8.0%, seen as worst case scenario. On the other side, FED rate hike against RBI rate pause in H2/2015, price appreciation into 7.70-7.80% is tough to sustain. Both combined, 10Y bond is seen to be in bearish consolidation mode at 7.80-7.90%. Based on this view, has already set 7.72-7.75% as duration-cut zone and 7.90-7.93% as duration-build zone and have seen back-and-forth move here more than once.
The set strategy is retained for rest of 2015 given the better clarity on the way forward. 10Y benchmark 7.72% 2025 focus retained at 7.72/7.75-7.90/7.93% not ruling out breakout bias into 8.0%. The strategy is to build book (and duration) at 7.90-7.92% and 7.98-8.0% for 7.71-7.73% and 7.63-7.65%, likely to be seen in H1/2016. The attractive "carry" against limited downside risk on value depreciation sets up good risk-reward investment opportunity.
Bearish consolidation is the preferred outlook
RBI is seen to have locked the short term focus at 7.78/7.80-7.90/7.92% through accelerated bond supplies at lower end through regular and OMO supply and not accepting bids beyond the higher end. The probability of rally beyond 7.78-7.80% into 7.72% is limited given the need for RBI to stay in $ buy mode to arrest Rupee appreciation beyond 63. It will be also against the interest of the Government to allow yield spike beyond 7.90-7.92% into 8% to incur higher cost on market borrowing to fund fiscal deficit. All combined, outlook for rest of 2015 is for stability in Call Money rate around Repo rate (seen steady at 7.25%), 91-364 T-bill yield at 7.35-7.60% and 10Y benchmark yield at 7.78/7.80-7.90/7.92%. This stance is seen good to retain CPI at 4/5-6% and Rupee stability at 63-65. The strategy is straight forward, to play end-to-end of 7.78/7.80-7.90/7.92% in 2015 and to build portfolio at 7.90-8.0% for 2016 rally into 7.65-7.72%.
Moses Harding
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