RBI has changed its stance to manage the expectations of the market. In the process, the yield curve has steepened already with long-end bond yields moving up. Once again, the Monetary Policy Committee (MPC) has voted 6-0 in favour of the decision and hold the rates clearly indicating that RBI does not want to be under “pressure” to cut rates any more and reserve the right to move “in either direction”.
In our opinion, RBI has taken a hasty step in changing the stance of monetary policy to “neutral”. They have overestimated the narrowing of the output gap or in other words, their thinking that GDP will bounce back smartly is too optimistic. We believe that data in coming months will show that industrial demand will take much longer to pick up and inflationary pressures will not be material. RBI has put the pressure back on banks to continue with monetary transmission to reflect the previous policy rate cuts of 175 bps which in RBI’s opinion has been passed on only between 80 to 90 bps. They have also nudged the Government to align the small savings rates in line with market yields.
The possibility of one more rate cut in the first half of CY 2017 remains high. Though this may be towards the end of the easing cycle, we do not see the risk of tightening of rates to begin soon. Global demand conditions are still subdued and unlikely to bounce back sharply. Whilst the consumption demand may improve with “remonetisation”, the credit demand from industry will take much longer to pick up. Banks are not witnessing any significant credit growth opportunities from the corporate sector, as is evidenced by the recent Q3 earnings. There is a move by the banks to reduce the deposit rates further and even lower the “savings bank rates”.
Investors in India are best placed to invest in the short to medium end of the yield curve (duration bucket of 1-3 years) and should prefer the accrual strategies compared to duration plays. RBI has committed to maintain the system liquidity conditions close to “neutrality” and that bodes well for the short end rates to remain low.