The RBI/MPC cut repo rate by 25 bps to 5.25%, with a unanimous vote. The stance was kept at ‘neutral’ with one dissent, who favoured a change to ‘accommodative’. The commentary was fairly dovish noting the undershoot on inflation and observing that both headline and core inflation are expected to be around the 4% target during the first half of 2026-27. Further the MPC noted that underlying inflationary pressures are even lower as the impact of increase in price of precious metals is about 50 bps. While growth is observed to be resilient now, there is expectation that it may soften somewhat going ahead. Importantly, the guidance is open ended enough for the market not to interpret this as a closing-of-the-door on any future monetary policy action.
The projection updates are summarised below:
The RBI announced liquidity measures as well including INR 1 lakh crores of OMO purchase (in two tranches of INR 50,000 crores each on 11th and 18th December) as well as a USD/INR buy/sell swap of USD 5 billion for a tenor of 3 years to be conducted on 16th December.
Takeaways
Apart from the headline takeaways as mentioned above, a key aspect of the policy today in our view was to be able to absorb some of the interpretational uncertainties of the market. The context going in was one of weaker inflation, stronger real growth in first half of the year (though with some statistical peculiarities), and some external account pressures reflecting in recent rupee weakening. Basis the sum total of these, the market had gone in quite confused with respect to likely action. Also, recent secondary market purchases of bonds by RBI had led some participants to believe that the central bank is trying to cap bond yields. Finally, from time to time, the market has tended to interpret RBI’s variable rate operations as signalling comfort / discomfort and accordingly there has been some propensity (though not much) to attribute directional monetary policy bias to these operations.
The outstanding feature of the policy today, in our view, was the clarity provided on almost all these fronts:
- The MPC statement clarifies the current reaction function on policy rate setting: First half growth has been strong but there are risks ahead. Inflation is low and underlying pressures are muted. This combination is enough to provide room for further monetary accommodation and keep forward guidance still open ended. Notably, the rupee doesn’t come in this calculation.
- The Governor notes: “I would further like to reiterate that the primary instrument of monetary policy is the policy repo rate. It is expected that changes in the short-term interest rates will transmit to various long-term rates. At the same time, the primary purpose of open market operations is to provide sufficient liquidity and not to directly influence G-sec yields.”.
This seems a breath of fresh air to us since, excluding the pandemic period, there has been no evidence in our assessment that RBI does OMOs to anchor bond yields. We make this observation simply because almost all OMO periods (including the current announcement) have been roughly predictable basis calculations of actual and evolving core liquidity. And yet sections of the market have always insisted that there are yield signals embedded.
- The Governor also notes: “So, it is quite possible that we inject durable liquidity through purchase of government securities under OMO on the one hand while simultaneously withdrawing transient liquidity through a VRRR operation on the other hand.”
Conclusion and Market Implications
The policy today is unequivocally bullish given both the actions taken and the interpretations provided. Should concurrent growth indicators weaken reflecting continued tariff uncertainties and possible fading off of ‘pent up’ GST cut impact on consumption, then market will not be able to rule out a final rate cut, though such a cut is likely to have very limited incremental utility. Thus, not only has overnight rate dropped today but the expectation channel for more isn’t fully shut down as well. This is a good combination for bonds.
That said, one has to also appreciate the somewhat lower flexibilities that we currently enjoy on both the external and fiscal accounts. Also, the underlying backdrop remains one of relatively low risk appetite for bonds and a likely rise in SDL supply into the year end. Thus, we don’t expect sustainable duration demand to re-emerge and think that the 5 – 8 year government bond sector remains the sweet spot.
This assessment reflects a long period of 5.25% (or lower) policy rate, RBI’s proactive stance on liquidity, and current valuation. At the time of writing, the 5-year government bond yield is around 95 – 100 bps over the current repo rate and 75 – 80 bps over the 1-year treasury bill. This also serves to emphasize the point that the yield curve is generally steep, and not specifically versus the long end alone. In our view, one should ‘receive’ this steepness at places where going forward appetite is likely to be stronger (5 – 8 year). The long end doesn’t pass that test for us at this point, for reasons mentioned above.
We had raised cash levels anticipating higher market volatility (Click here). The recent few days post stronger real GDP and weaker rupee had disturbed market rate cut expectation and led to rise in yields and some bear flattening of the yield curve. We used that opportunity to deploy back our cash positions and we are back to being overweight 5 – 8 year government bonds. We expect the sovereign curve to remain steeper, and this strategy reflects the expectation. On the other hand, the corporate curve may see stickiness at the 1-year point given rising credit to deposit ratio. Also spread assets (duration corporate bonds and SDLs) may underperform equivalent tenors government bonds into the fiscal year end. We expect RBI to most likely follow through with another INR 1 lakh crores of OMOs after December.
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