The Monetary Policy Committee of the Reserve Bank of India kept the Repo rate unchanged at 6% in its meeting on February 6th, although one of its members voted for a 0.25% hike, according to the minutes released by the central bank on Wednesday. The MPC has six members including the RBI Governor.
The RBI had been in a rate-cutting mode over the past four years since Jan 2014 when its Repo rate peaked at 8%. This meeting marked the end of this rate cutting cycle and the start of a reverse move – towards hiking rates. A major indicator of such a possibility is the dissenting vote of one of its members – Michael Patra, who voted to hike rates by 0.25%.
Patra stated that, although he had expressed a preference for a pre-emptive hike in April 2017, he waited for transitory inflation effects to pass in the June and August MPC meetings. His views on the possibility of higher than expected inflation are now being vindicated. He further observed that several factors were fanning inflationary flames simultaneously – MSP hikes, custom duty hikes and fiscal slippage. He expects inflation to move well above the RBI’s target band (4-6%) till mid-2018.
The MPC meeting, chaired by Governor Urjit R. Patel, was attended by all the members – Dr. Chetan Ghate, Professor, Indian Statistical Institute; Dr. Pami Dua, Director, Delhi School of Economics; Dr. Ravindra H. Dholakia, Professor, Indian Institute of Management, Ahmedabad; Dr. Michael Debabrata Patra, Executive Director (the officer of the Reserve Bank nominated by the Central Board); and Dr. Viral V. Acharya, Deputy Governor in charge of monetary policy.
What does this mean for you?
As a borrower and depositor
The RBI’s Repo rate is highly connected to the overall interest rate in the economy. The Repo rate is the rate at which the RBI lends money to banks. An increase in this rate not only increases the cost of funds for banks but also serves as a signal to them to raise their own rates. This is passed down to consumers through both higher loan rates. Deposit rates are also hiked, but this often happens with a lag, as banks move to protect their profits.
As a debt fund investor
An RBI rate hike affects the yields on government and corporate bonds which are held by debt mutual funds which in turn causes the Net Asset Value (NAV) of debt funds to fall. How much does this NAV fall? The answer is given by a measure called ‘Modified Duration.’ Modified Duration is the percentage change in the value of a bond or bond portfolio for a percentage change in interest rates. For instance, a Modified Duration of 5 means that a 1% hike in interest rates will cause the value of the bond portfolio to fall by 5%. This is because bond values move in an inverse direction to interest rates. You can get an idea of the modified duration of your debt funds from the fund’s website.
The benchmark bond yield
Market interest rates have already moved up in anticipation of rate hikes. The 10-year Government of India benchmark bond yield is 7.75% which is nearly two percentage points higher than the repo rate. It has moved up more than a 1% since its recent low of 6.4% in August 2017. Keep a watch on this rate as it directly reflects the damage your debt funds might take. We tell you more about this here.
As an equity fund investor
A rate hike does not directly hurt equity fund investors but has the potential to indirectly to do so. A rate hike increases the borrowing costs of companies and hence decreases their earnings. In case of banks, it also hurts their net worth because banks typically hold a substantial level of government bonds on their books. As a result, a rate hike is likely to disproportionately hurt a banking sector fund or a diversified fund which has a heavy exposure to banks.
What should you do?
If you are a fixed deposit investor, avoid locking yourself into long-term fixed deposits.
If you are a debt fund investor, stay with liquid, ultra short-term or short-term funds. These have the least sensitivity to interest rates in that order. Look up your fund’s modified duration along with other risk measures such as credit quality.
If you are an equity fund investor, be wary of banking sector funds or funds which have excessive exposure to the banking industry.