The Reserve Bank of India's Monetary Policy Committee (RBI MPC) hiked repo rate by 50bps to 5.90 percent with immediate effect on Friday. This is the fourth rate hike we have seen in a row - after 40bps in May, 50 bps in June and 50 bps in August.
This was in line with our base case assumption. Five members voted for 50 bps increase. One member (Dr Ashima Goyal) voted for 35 bps. This indicates start of divergence in terms of future trajectory of rate hikes too possibly. Five members voted to remain focused on the withdrawal of accommodation to ensure that the inflation remains within the target going forward, while supporting growth. One member (Dr Jayanth Varma) voted against.
Outlook and way forward
The headline consumer price index (CPI) is likely to be above the RBIs tolerance level of 6 percent through most parts of FY23. Similar trend is visible globally, though we seem much better for now. While crude oil prices have eased, food prices still remain sticky leaving limited head room for a major dip in CPI. The late recovery in sowing augurs well for kharif crop output. The prospects for the rabi crop are buffered by comfortable reservoir levels. The risk of crop damage from excessive/unseasonal rains, however, remains. These factors have implications for the food price outlook.
Global growth concerns may continue to linger, we see more headwinds than tailwinds for now.
We have seen cumulative 1.9 percent repo rate hikes from May. Pace The pace of rate hikes could recede, maybe one more rate hike is possible in the December policy (though global developments may continue to weigh in). We are quite close to the neutral rate if one looks at RBIs CPI forecast, hence incremental rate hike could at best be an insurance rate hike.
Since last policy (August 5), short end of the yield curve has inched up around 50-60 bps in response to Fed rate hikes. The OIS (interest rate swap) curve is now pricing in terminal repo rate at 7 percent, implying another 110 bps rate hike! We assign a lower chance of this occurrence as of now.
What should investors do
For fixed income investors, the risk reward continues to favour ownership of the mid-end of the yield curve (3-5 years) as yield curve has considerably fattened – i.e. short end yields have risen faster than long end yields.
We saw the announcement of the second half (H2) of FY23 borrowing calendar recently, where there has been a marginal reduction in government borrowing. This could act as a small anchor to bond yields in the near term. Also, floating rate bonds (FRBs) saw continued supply in H1 FY 2023. With no supply in the second half, one could expect some re-rating to happen in that segment. For eg. the reset coupon on FRB 2033 is at 7.43 percent - higher than the 10-year Gsec yield! Investors could look to allocate some funds into this category, with atleast a 12-18 m investment outlook.
Foreign flows in fixed income have remained net positive for 2nd straight month in row (August and September 22 till date). India bonds Index inclusion continues to remain in the known unknown quadrant (known that it may happen, unknown in terms of timing). Given the INR vulnerability and possible delayed gratification in index inclusion news, FPI momentum could slow down a tad. However flows by domestic retail and institutional investors could continue to chase the carry. Investors looking for a higher degree of certainty could look at allocation to target maturity fund category – as interest rates remain elevated.
Bottomline – the uncertainty factor in markets may continue to exist as global scenario is still fluid. India policy moves incrementally would be data dependent toggling between relatively week global cues and more resilient domestic data.
Investors could look at a staggered investment approach to fixed income to ride out this volatile phase – both from carry perspective initially and potential capital gains subsequently. We are of the view that active and passive funds can co-exist in investor’s portfolio given the current interest rate scenario.
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