The monetary policy committee (MPC) voted to cut repo rate by 25 bps to 5.15%. The decision to cut was unanimous although one member wanted a larger 40 bps cut. This is largely in line with market expectations, although lately views of a larger 40 bps cut were also beginning to gain ground.
Assessment
A summary of changes in projections is included in the table below
Growth
Global growth slowdown continues and the recent supply-shock driven crude oil spike has unwound faster than expected. Financial markets remain uncertain while globally central banks are increasingly turning more accommodative. Domestically, the drastic slowdown in Q1 Gross Domestic Product (GDP) has been followed by softer higher frequency indicators. Indicators of rural and urban demand have continued slowing, while RBI’s own survey also shows weak consumer sentiment. On the positive side, monsoons have picked up substantially with corresponding pick up in kharif production. Rabi crop prospects in particular have turned quite robust as a result of late rains. The Governor noted that manufacturing and construction data looks better in August and some service sector indicators may be slightly better as well. All in all, growth has been substantially revised downward to 6.1% from 6.9% before. That said, and basis signs of further local and global slowdown lately, it is likely that even these revised expectations will be disappointed.
Inflation
On CPI the RBI has marginally adjusted upwards its forecast for Q2 , to basically reflect the actual progression over this period. For the rest, the forecasts are largely unchanged. Household inflation expectations have recently risen (40 bps over 3 month horizon and 20 bps over 1 year horizon). However, this is being (rightly) underplayed by the RBI. The assessment is that this may be owing to households adaptively responding to the rise in food prices in recent months. Whereas, RBI’s own consumer confidence survey shows weak consumer sentiment and tepid consumption demand, especially relating to non-essential items. Manufacturing firms also see weakening of demand conditions in Q2:2019-20 and Q3 and expect their output prices to soften, going forward, as the cost of finance and salary outgoes remain muted.
Transmission
Notably, monetary transmission has remained “staggered and incomplete”. As against the cumulative policy repo rate reduction of 110 bps during February-August 2019, the weighted average lending rate (WALR) on fresh rupee loans of commercial banks declined by 29 bps. However, the WALR on outstanding rupee loans increased by 7 bps during the same period.
Liquidity
The Governor explicitly clarified that the recently released liquidity framework report is a work of an internal working group that has been now put up for public comments, and does not reflect the institutional position of the RBI. This is important as the report had been generally found to be underwhelming, breaking little new ground or even acknowledging any meaningful shift in thinking with respect to targeted quantum of liquidity in the system. To that extent, the clarification is a relief and the market may continue to believe that stance remains of adequate positive liquidity premised on the old adage of actions speaking louder than words.
Fiscal
The Governor continued forward his largely sanguine view on the fiscal, choosing to take the government on face value and still (at least in a manner of speaking) not looking for slippages. He also underplayed the effect / impact of any so-called crowding out from government borrowing.
Takeaways
This policy re-emphasizes the important break that the Governor Das RBI has executed from the past: the full deployment of all three pillars of rates, liquidity and guidance. The guidance is the strongest yet with the Monetary Policy Committee (MPC) deciding to continue with an accommodative stance as long as it is necessary to revive growth, while ensuring that inflation remains within the target. Governor Das re-emphasized this in his press conference as well saying that as long as growth momentum remains as it is and till growth revives, RBI will be in accommodative mode. Thus while we may be closer now to the terminal rate in this cycle, investors need to focus on the other more important aspect: that barring an unforeseen global development it is very likely that the policy rate remains around the 5% mark for an extended period of time. The same interpretation will likely hold for the stance around ensuring abundant positive liquidity as well. This will mean that front end rates remain very well anchored. Investors may need to shift focus from looking at only potential mark-to-market gains from falling rates to looking towards ‘receiving’ the steepness in the curve built into the front end versus the immediate overnight and money market rates. The relative stability that one foresees in policy rates and liquidity should also translate into stability (with easing bias) in quality front end rates.
For long duration (10 year and beyond) the term spread will also be influenced by supply dynamics. There are 2 points to ponder here: 1> The potential fiscal risks that may manifest for the central government thereby translation into additional bond supply. It is to be noted that the current second half calendar is slated to end by January, thereby providing enough time for extra borrowing. At this juncture we are anticipating a 40 bps slippage to the deficit target, although this entire slippage may not necessarily translate into equivalent borrowing. As noted before, however, the current net supply of government bonds is quite smaller compared with the first half. 2> This is the bigger worry and pertains to states’ financing and consequently state development loan (SDL) supply. We are expecting gross SDL supply to touch close to INR 6,00,000 crores in the current financial year, almost 30% higher than last year.
As a result of the dynamics mentioned above, we would expect the yield curve to start to steepen overtime. This is reflected in our preference for 5 – 7 year government bonds in our active duration funds. High quality short term products also look attractive in this backdrop. We remain cautious on credit where valuations are still not being backed by narrative.
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