This is a guest article by Suyash Choudhary, Head – Fixed Income, IDFC AMC:
The RBI cut policy rates by 25 bps to 6.25% (voted 4-2) and changed the monetary policy stance from ‘calibrated tightening’ to ‘neutral’ (unanimous vote).
Some key points
1. The MPC cut its CPI forecasts, with Q4 FY19 now being forecasted at 2.8% y/y (vs. the lower-than-expected actual print of 2.6% in Q3 FY19 and previous forecast of 2.7-3.2% for H2 FY19) and H1 FY20 at 3.2-3.4% (previously 3.8-4.2%). CPI for Q3 FY20 is forecasted at 3.9%. It assessed the risks to be broadly balanced around the central trajectory vs. ‘tilted to the upside’ earlier. The MPC noted its benign food inflation outlook, softer prices of items in the fuel-group, complete dissipation of the recent HRA hike and its current judgment of the recent jump in health and education CPI components to be a one-off phenomenon. However, it highlighted the reversal in vegetable prices, unclear oil price outlook, rising trade tensions, volatility in financial markets and the impact of various budget announcements (although only over a period of time) on increasing disposable incomes as upside risks.
2. On GDP growth, it noted slowing global growth/demand, rising trade tensions and the recent pickup in bank credit growth not being broad-based as headwinds. It projects FY20 real GDP growth at 7.4% (7.2-7.4% in H1 and 7.5% in Q3), with risks evenly balanced. Further, it mentioned the output gap has inched lower than potential (earlier assessment was it had closed) and the need to step up private investments and support consumption. On the global front, it acknowledged the recent moderation in economic activity in the U.S., Euro Area and China.
The rate cut decision taken by the MPC is understandable, although market (including ourselves) had assigned a less than even chance of that happening today. This is largely owing to the context provided by the Budget and the expectation that the recent jump in core CPI, although owing largely to rural health and education, may cause RBI to take more time it its assessment. However, the cut can be justified owing to the persistent undershoot in headline CPI as well as more sanguine global environment, including worries on global growth. Indeed, that has been our framework for some time now. What stands out, however, is that the assessment is considerably more sanguine on almost all aspects. As an example, the governor actually stepped in to defend the GST collection targets set by the government in the new budget; one which has been viewed with suspicion by most. Also, the impression given is that the new revised CPI targets take into account possible impact from the consumption stimulus offered by the government in the budget.
The policy clearly has the stamp of the new governor. Assessments are bolder and interpretations are more sanguine. There is clear benefit of doubt for the government. Also, the focus seems to be conclusively back on headline CPI. All this means that the market may look forward to at least one more rate cut, given that the near forecast for CPI remains sanguine. Against this tailwind, however, the government is slated to borrow INR 36,000 crores extra in this financial year and a higher than expected INR 7,10,000 crores in the next financial year.
The obvious implication is for the yield curve to steepen as the market is called upon to take higher supply at the duration part of the curve. In duration, our preference would be for quasi like SDL and corporate bonds rather than government bonds. While as for supply, there is a near term problem, it typically dissipates into the new financial year. Also, in starting spreads, it’s already reflecting a higher supply. The most sustainable trade, however, is in 2-5 year AAA corporate bonds.