The bond market took the RBI policy gladly and used it to build on the momentum already established since the announcement of the H1 borrowing program. Specifically, the bond market took positively the downward revision to RBI’s CPI forecast for the year ahead, as well as its specific focus on the CPI ex-HRA in the written policy document. Some of the noteworthy specifics, in our view, are as follows:
1. CPI forecast for H1 FY 19 has been reduced from 5.1 – 5.6% to 4.7 – 5.1% and for H2 from 4.5 – 4.6% to 4.4% in H2, but with risks tilted to the upside. Excluding impact of HRA revisions, CPI is projected at 4.4 – 4.7% in H1 and 4.4% in H2. It is to be noted that these are very close to the target of 4% and if achieved effectively rule out any rate hike. A prolonged pause is anyway our base case view.
2. However, most of the risk factors mentioned are to the upside. Thus the MPC notes the possible impact of MSP revisions that will be known only in the coming months, the risks from possible second round effect of HRA increases, the possibility of near or medium term fiscal slippages from centre and / or states, possible risk from monsoons, risks to inflation from companies expecting higher input and output prices, and crude price volatility. More fundamentally, the MPC also assesses that growth has been recovering and output gap closing as also reflected in a pick-up in credit growth in recent months. The MPC also notes that household inflation expectations have edged up both for 3 months and 1 year horizons.
3. The growth outlook is largely sanguine with rising investment activity locally and improving demand globally. GDP is expected to strengthen from 6.6% in 2017 – 18, to 7.4% in 2018 – 19 (H1 range of 7.3 – 7.4% and H2 of 7.3 – 7.6%) with risks evenly balanced.
Takeaways and Implications
The policy today serves to take away lingering risks of a near term hike, although most of these may have already started to get addressed with the recent sharp fall in CPI. Having said that, while the starting point on CPI for the next financial year is lower, there is still little color on the risks that lie ahead. The MPC has noted as much and, as discussed above, its list of risk factors runs large. Many of these will only begin to get clarified over the next few months and the MPC will have to be alive to how these evolve. However, a long period status quo on policy rates continues to remain our view.
From a bond market standpoint, the policy has provided an additional momentum to the recent rally. With this, however, the curve has flattened unsustainably; in our view. Thus spread between 5 and 10 year government bonds is less than 10 bps at the time of writing.
We have used this to trim our tactical long positions in the so-called ‘belly’ (10 – 14 years). In our active bond funds we continue to run 10 year proxies like SDL and corporate bonds to some extent. However, for the most part we are very overweight rates up to 5 – 7 years. These stand to benefit the most going forward, in our view, given no immediate fears of rate action and the very flat yield curve. Banks are also likely to prefer this segment given larger reluctance to add duration post recent experience, and especially at lower yields. Pure front end strategies like ultra short, short, medium term also look very attractively poised especially with the latest relief from RBI expectations.
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