As a guidance for debt fund investors, for incremental money, the RBI is set to gradually hike interest rates.

The Monetary Policy Committee (MPC) members decided to keep interest rates unchanged, at least for now. Broadly, the path of interest rate from now onwards is upwards, which is referred to as normalization, as rates are currently very low. The reason for low interest rates is the challenge to the economy emanating from the pandemic. “Cheap money” makes people take loans, which in turn drives the economy. The question at this juncture is, whether the RBI will start normalizing rates now, or later. The debate is not about whether they should, but when.

The reason for normalizing (read increasing) interest rates is that inflation is high, and low interest rates are a drag on savers, particularly senior citizens. When the country is facing a severe challenge, everyone has to come forward and contribute. In the challenging phase, low interest rate was the contribution from savers, as they earned negative real (net of inflation) returns. As we travel the path of rate normalization and inflation eases, things should normalize for savers.

Going easy on rates

The backdrop to the policy review meeting on December 8, 2021 was that on the one hand economic growth is reviving and inflation is a concern (i.e., reasons for rate normalization), and on the other hand the latest variant Omicron is a threat to growth, which means interest rates must be kept low for some more time. In the meeting, the MPC decided to maintain status quo. Not only were interest rates maintained, other variables were maintained as well. What are these other aspects?

-There was a monetary policy stance, which currently is “accommodative,” i.e., preference for keeping interest rates low, supportive of economic growth;

-There was a projection for GDP growth, which was maintained at 9.5 percent for the year 2021-22, same as in the previous policy review;

-There was a forecast for CPI inflation, which also was maintained at 5.3 percent for 2021-22, same as in the previous policy review.

What would have prompted the MPC to maintain status quo? Going into the review, it was a debate on whether it should start the normalization now or later. On top of it, the threat from Omicron variant impacted sentiments. Though we do not know what would be the extent of damage (e.g., lockdown or other restrictions), it is a concern nonetheless.

Preparing for higher rates via VRRR

Earlier, RBI had already started giving signals to the money market on rate normalization, which is not so evident in the public domain. The RBI has been working out a Variable Rate Reverse Repo (VRRR), which is of  more than one-day tenure. There is a daily fixed rate reverse repo, which happens at 3.35 percent. The VRRR happens at a higher rate, and the RBI has been increasing the quantum of money absorbed through VRR. Currently, it is much higher than the daily quantum. The implication is that when the RBI actually hikes the reverse repo rate from 3.35 percent, it would not make as much of an impact on the money market. Eventually, the RBI will have to hike the repo rate – currently at 4 percent – which is taken as signal interest rate for the entire economy.

As the RBI does its job of deciding on appropriate interest rates for the economy, what is the implication for investors? As of today, nothing changes. The bond market has reacted positively, as the accommodative stance on interest rate has been maintained and the projection on inflation has been maintained at 5.3 percent, though a section of the market is expecting marginally higher levels. The equity market has reacted positively, as money availability at cheaper rates is good for the market. Your basis of portfolio allocation to equity, debt or any other asset class is anyway not dependent on the current market level, but on your investment objectives, risk appetite and time horizon. If it is about tweaking your portfolio to changes in the market, nothing changes after the policy review.

As a guidance for debt fund investors, for incremental money, the RBI is set to gradually hike interest rates. The next review is on February 9, 2022, when there is a possibility of a hike in the reverse repo rate, and sometime later, a hike in repo rate. As and when that happens, the impact on debt funds is going to be adverse, as interest rates and bond prices move inversely. If you want to play it defensively during the phase of increasing rates, you would prefer funds with relatively shorter portfolio maturity, as the impact is relatively lesser.

Source: https://www.moneycontrol.com/news/business/personal-finance/rbi-maintains-status-quo-but-continues-to-send-indirect-signals-on-tightening-interest-rates-7806691.html