Central Bank remains vigilant on potential supply shocks in the form of vagaries in food prices and crude.

By DHAWAL DALAL

As expected, the Monetary Policy Committee (MPC) kept the Repo rate unchanged at 6.5%. The only change was the voting pattern with one MPC member voting for a rate cut.

This possibly suggests some conversation on a potential rate cut in the medium term. Bond market participants are pricing in the first cut in the Repo Rate in June 2024 MPC policy provided growth-inflation dynamics remain favourable.

RBI’s assessment of the economy was satisfactory. RBI has acknowledged the ongoing fiscal consolidation in terms of the declining trend in fiscal deficit in the interim budget. This will have a positive impact on the demand-supply dynamic of government bonds and yield curve.

RBI has stuck its neck out and expects FY25 real GDP growth at 7%. This is even more bullish than GOI’s own forecast for economic growth for FY25. This higher degree of confidence in economic growth may be aimed at guiding economic agents to plan accordingly.

RBI has also been more comfortable with the trajectory of the headline inflation in FY25 and has been satisfied with the ongoing disinflationary trends in the core inflation. That said, RBI remains vigilant on potential supply shocks in the form of vagaries in food prices and crude oil prices.

On banking system liquidity, the RBI has changed its tack in 2024 after a spike in banking system deficit in Dec 2023 although the RBI governor hinted that overall banking system liquidity was positive if one considers government cash balances.

RBI will be proactive in modulating frictional and durable liquidity going forward and will deploy all tools necessary for the same. This probably means a potential cut in the Cash Reserve Ratio (CRR) in case of prolonged deficit as well as Open Market Operations (OMO) sales in case of a sharp surge in banking system liquidity, in our view.

What does this mean for the bond market?

We believe that today’s MPC was a bit bullish on the economic growth front. At the same time, a tad cautious on the inflation front for valid reasons. The RBI is happy with the trend in inflation but does not want to call it a victory yet and has stressed the importance of a 4% inflation level as RBI believes 4% inflation will give us a bedrock for stronger economic growth. Based on this, we expect RBI to consider easing policy rates in the June 2024 MPC meeting.

Sovereign bond yields have declined since December 2023 MPC meeting with the benchmark 10-year yield falling by 20 basis points to 7.07% while 30-year IGB yield easing by ~30 bp to 7.13% after the policy outcome. Thus, the IGB yield curve has experienced “bullish flattening”.

With spreads between the 10 & 30-year IGB at historic low, we believe value is gradually emerging in the 10-year segment of the yield curve. We expect benchmark 10-year IGB to gradually trend towards 6.90% level first by mid-2024 and then towards 6.75% after the commencement of the rate cut cycle.

What should investors do?

We suggest investors consider increasing duration in their fixed income portfolios through sovereign bonds maturing in the 10-year segment amid historically tight spreads on the long end.

We also believe that SDLs and corporate may underperform IGBs in 2024 as we expect credit spreads to widen further from here due to potentially higher primary supply in CY24. (The author is President & CIO – Fixed Income, Edelweiss Asset Management Limited)