The MPC cut repo rate by 25 bps to 6% and changed policy stance to ‘accommodative’, in an unequivocally dovish move. In its assessment, it noted the progress on inflation and that the outlook on food inflation has turned decisively positive. Vegetable prices have fallen, and uncertainties related to ‘rabi’ production have abated considerably. Inflation expectations for both 3-months and 1-year horizons have declined sharply while oil prices have also fallen recently. Thus, there is now a greater confidence of durable alignment of headline inflation with the 4% target over a 12-month horizon.
On the other hand, growth is still on a recovery path post an underwhelming first half of FY25 and fresh possible adverse implications here are developing from recent global trade and related policy uncertainties. Thus, RBI/MPC assessment from recent global developments is of more concern for growth rather than for inflation. This also serves to justify the change in stance which communicates likelihood of only one of two possibilities ahead: either hold or cut.
Some Important Questions (And Their Tentative Answers)
As important as the RBI policy outcome is, there is a bigger picture in play at the moment, and one which is prone to rapid plot twists. The extent of US tariffs imposed have been way above what most forecasters would have envisaged. This implies, to various degrees, higher inflation and lower growth. We ask and try to answer some relevant questions below in this regard.
- What will the Fed do?
As per the Fed’s policy framework when the two mandates on inflation and employment are in tension, then the Fed will respond to that variable that is the most away from its mandated target, while also accounting for the likely time taken for each variable to get back to mandate. However, the context and effects in the current circumstance may make this interpretation difficult. On the one hand, the US has had a strong recent inflationary episode. While this has settled down, partly because of rapid monetary tightening, inflation is still not at target. Thus, a new inflation shock, such as the one that tariffs can bring, may raise fresh alarm bells at the Fed.
On the other hand, while growth has been above trend and the labor market has been relatively strong, there have been things happening under the hood which suggest all hasn’t be as well. As an example, the labor market lately has been largely frozen with both hiring and exits relatively low. Thus, people in employment are doing okay but it is becoming increasingly difficult to find new employment or switch jobs. A growth shock on such a template may lead to a meaningful rise in unemployment.
Further complicating the scenario, the direct first order effect on inflation from the tariffs may indeed be quite significant but may translate into second round effects with considerably lower intensity given the concurrent weakening in demand. However, there may be more durability to the rise in unemployment. The Fed’s focus for interpreting this complexity, and as already indicated by Fed leadership, will likely be on evolution of medium term inflation expectations. If rise in short term expectations don’t translate into corresponding medium term inflation expectation rise, then the Fed will be able to respond to a weaker labor market by cutting rates. Indeed, market pricing at the time of writing is of almost 5 rate cuts over the next one year. That said, the Fed may retain a level of prudence in its extent of monetary easing versus previous such episodes. Thus, risk assets may well have to contend with a much weaker Fed ‘put’ than before in the face of an economic slowdown.
- How will the dollar react?
The traditional template is for the dollar to strengthen into a risk-off event as investors flee to the so-called safe haven currencies. In the current episode, while there has been some bounce in the broad based dollar index over the past few days, the reaction still seems quite mixed if one considers a slightly longer time-frame of a week or so. It is still early days, so one shouldn’t draw too many conclusions just yet. That said, the going in context this time has been the almost overbought US exceptionalism trade. With a dent to this expectation, and given the starting point of hefty overweight US capital allocations, there may be a diversification out as well which may (hopefully) work against any meaningful strengthening of the dollar over the risk-off phase.
- Will China devalue its currency?
Market chatter has re-emerged over the past few days that China may devalue the yuan in retaliation to the hefty trade-tariffs imposed on it by the US. This will be to try and shore up some export competitiveness as a part offset to the tariffs. This is important for us to evaluate since any sudden and substantial weakening of the yuan may put pressure on the rupee as well with consequent implications for capital flows to us and the impediment it poses to transmission of RBI’s easing.
However, drawing from what was seen in the previous episode of policy driven devaluation ten years back, we think this is highly unlikely. Over the period following that episode, there had been large scale capital outflows from China that took a long time to stabilize. Thus, a repeat of this risk will have to be actively weighed against any trade benefits from an active devaluation. It is to be noted that we are drawing a distinction here between policy driven devaluation versus some currency weakening as per usual market dynamics.
- How much room will RBI have?
RBI’s reaction function, especially post the policy today, is quite clear and predictable. Unlike in the US, there is little tension here between growth and inflation, at least for the time being. This allows RBI to focus more whole-heartedly on growth. The narrowing of India-US rate differential is, to a certain degree, not as much of a constraint. This has been adequately shown over the past few years. This is because the US has had a reset on fiscal and inflation dynamics which is well recognized by global investors who are happy to accept lower yield differentials in well-run other geographies. That said, this argument can only be made to a degree, and for effective RBI easing to continue the broad interpretations made by us for points 1, 2, and 3 above should hold.
Effectively utilizing the available monetary policy space is also important, since it is very important in our view for the government to continue holding its conservative fiscal stance. Earning medium term fiscal credibility will pay long term dividends, something we believe the government well appreciates already. To clarify, should there be a slowdown in growth some marginal fiscal expansion may well occur involuntarily as tax revenues slow. This should be looked through and one shouldn’t try to compress expenditures in an already slowing economy. However, absent a meaningful economic shock, active fiscal expansion should not be undertaken in our view.
All told then, and considering the revised realities on global growth, we now expect terminal repo rate to be 5.50% from 5.75% earlier. We also expect RBI to remain very proactive with liquidity conditions, ensuring enough positive liquidity (likely between 1 and 2% of NDTL of banks, though the Governor has refused to commit to a quantification) to enable smooth transmission of rate cuts.
Conclusions and Investor Takeaways
To make an obvious point, what we are seeing on the world stage today is an amplification of a direction of de-globalization that had commenced quite some years back. However, the current escalation is so dramatic that it almost by definition cannot translate into the business as usual. For that reason, one has to assign a limited shelf life to the extent of tariffs in play today. However, while de-escalation may offer significant relief, the format of uncertainty is likely to last. This will still work as a headwind to growth and private sector investment intentions around the world. In such a scenario, local policy predictability can offer an important counter-point and relief. The monetary policy decision and articulation today served an important function in this direction.
Investors are getting a very conducive environment for fixed income, albeit with some volatility from the world thrown in from time to time. Hence, they should continue focusing on mitigating reinvestment risks via adequate duration selection in our view. In making these selections they should be mindful of their appetite for near term volatility, even as the prospects of such volatility shouldn’t translate into inaction that amplifies future re-investment risks.
Disclaimer:
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of Bandhan Mutual Fund (formerly known as IDFC Mutual Fund). The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the security, if any, may or may not continue to form part of the scheme’s portfolio in future. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. The decision of the Investment Manager may not always be profitable; as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement/document as may be required from time to time. Neither Bandhan Mutual Fund (formerly known as IDFC Mutual Fund)/ Bandhan Mutual Fund Trustee Limited (formerly IDFC AMC Trustee Company Limited) / Bandhan AMC Limited (formerly IDFC Asset Management Company Limited), its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information. Past performance may or may not be sustained in future.