Why Investors Should Look At Inflation Points

After RBI’s 25 bps rate cut, investors in long bond funds should stay invested and look to exit either when market runs ahead expecting the next rate cut or when inflation looks to breach the central bank’s comfort level.

In bond market parlance, bps, i.e., basis points is also referred to as ‘paise’. There was a time, decades ago, when char anna or 25 paise was worth a lot. Somewhere along the line, with inflation and all, char anna or 25 paise went into oblivion. It is when the RBI Monetary Policy Committee (MPC) met and cut policy rate by 25 bps, we remember 25 paise. In the run-up to the Policy Review of August 2, we all knew that inflation has surprised on the downside (CPI at 1.54% in June), GDP growth has taken a breather and that the entire market was expecting 25 bps rate cut. What was unique in the run-up to this policy review was that the country’s largest lender State Bank of India (SBI) reduced savings account deposit rate by as much as 50 bps (eight anna in yesteryear parlance), re-emphasising the direction of interest rates in India.

The policy review outcome was on expected lines, with the RBI delivering the char anna, i.e., 25 bps rate cut. The repo rate, also referred to as the policy rate, has been reduced from 6.25% to 6%. Repo rate is the rate at which banks borrow money from the RBI, for one day, when they are temporarily short of funds. Consequently, the reverse repo rate, the rate at which banks park surplus funds with the RBI for one day, goes down to 5.75%.

In every policy review, the RBI communicates a ‘policy stance’ to interest rate formulation, which is either stated as such or implied from the statements made. In the review on February 8, 2017, the stance was changed from ‘accommodative’, i.e., leaning towards rate cuts to ‘neutral’, even though there was no apparent reason. Even within the ‘neutral’ stance to policy rate formulation, the RBI can reduce interest rates, should the situation warrant.

This is what has happened in the latest review on August 2, 2017. In view of remarkably low inflation, the RBI has reduced rates but have maintained the neutral stance. The question that opens up now is whether there is scope for another char anna either in the next meeting on October 4 or later. A cautionary note has been sounded about inflation, that it may rise to 4% by the fourth quarter, i.e., January-March 2018. This means policy rate formulation will be data dependent, based on forthcoming inflation data, inflation expectations and other relevant date like GDP growth, credit off-take, etc.

Caution on inflation

Notwithstanding the caution sounded about inflation, and notwithstanding that there is no hint given in this policy about further rate cuts, the scope remains for further rate accommodation. Real interest rates are positive, and comfortably so vis-à-vis RBI’s comfort level. The parameter for interest rate is the yield level on 1-year Treasury Bill. Taking that at 6.25%, or a little lower after the latest rate cut, and inflation at 3-3.25% as a representative number, there is a clear 3% real rate, which is high by historical standards. As long as inflation is lower than RBI’s focus of 4%, there will be a case, and market expectation of, further char anna easing measures.

The bond market has not reacted much to the latest policy rate cut, yield levels in the secondary market are similar to the levels prior to the policy announcement. Markets act in advance and the latest rate cut was already discounted. As and when we continue to get favourable inflation data prints, never mind high tomato prices, market will continue to expect rate cuts. For investors in long bond funds, stay invested for now and look to exit when inflation looks to breach RBI’s comfort level or the market has run up too much.

Source: https://www.financialexpress.com/economy/why-investors-should-look-at-inflation-points/797065/

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