Something for everyone: Hold for bond market, change in stance for FX market

In a nutshell, the RBI’s decision to keep the policy rate unchanged can be understood as a clear choice between two alternatives.

• One, the domestic bond yields and interest rates in the wholesale market have risen sharply. So it was best not to increase the pressure there. Plus the problems in the NBFCs which could become a generalized issue of liquidity crunch and higher borrowing cost – clearly deserved some attention. Thus, a hold in the policy rate was preferred.
• This could be pitched against the other option, that is the risk of not containing the depreciation pressures on the rupee and allowing the spillover to other asset classes like equities to continue. This could make a case for a hike and a stronger communication. However, the RBI made a clear choice and underplayed this risk.
•  Although the external risks would manifest in the form of higher oil prices and deprecating currency; these risks were not yet seen as a big enough threat to RBI’s inflation projections, especially given the benign trajectory of food prices in recent months. Thus, being cognizant of the external risks, the RBI for now only decided to change its stance to keep the door open for future rate hikes.
• Implications: While the hold in rates could bring some cheer for the bond market, the FX markets would clearly be disappointed given that expectations were running high.

RBI surprises, holds repo rate at 6.5% but stance turns hawkish

The RBI in an unexpected move decided to keep the repo rate unchanged at 6.50%. The vote to stay on hold was advocated by five out of six members in the monetary policy Committee (MPC). The RBI justified its stance by reducing its inflation forecast for H2-FY19 and 1Q-FY20, saying that its mandate is to control inflation and not to defend any particular level of exchange rate. Going by this mandate, the MPC mentioned that the risks related to imported inflation (because of depreciation pressures and rise in oil prices) have been taken into account but at this stage such risks could be mitigated by benign food inflation.

The RBI seems to be giving more weightage to domestic side issues:

• The decision to keep policy rates unchanged could be seen as a series of steps to cap the cost of borrowing in the domestic markets (after liquidity easing measures were announced last week). On account of liquidity issues for the domestic NBFCs, risk of fiscal slippage, rising oil prices, and depreciating currency, the cost of borrowing in the domestic wholesale market has already gone up by around 36 bps (on average the upward shift in yield curve for India since the last MPC meet in August). A rate hike today would have further aggravated the pressure in the interest rates. Perhaps, the other way of looking at it is that when the recovery in private investment cycle is in its nascent stages, there could be a risk of over-doing the hike in interest rates. At this stage, the RBI seems to be okay with the 50 bps hike done in this cycle and the simultaneous rise in interest rates in the wholesale market that has come so far.

• Looking at the pressure points on the external front, vis-à-vis increase in policy rates by other central banks, depreciation in currencies throughout the emerging world, and FII outflows from the domestic bond market, perhaps there was a case to hike the policy rate today but the RBI decided to give higher weightage to domestic side pressures. Meanwhile, the RBI changed its stance from ‘neutral’ to calibrated tightening’, leaving the door open to act in case the rupee depreciates more and oil prices rise further.

Implications for the FX and Bond Markets

• In response to the RBI’s decision, the benchmark bond yield has dropped around 13 bps and the depreciation pressures on the rupee have aggravated. Going forward, there is now an upside risk to our USD/INR call of 70-71 for December-end. It is clear that the RBI would let the market forces prevail and would not try to defend any particular level of exchange rate. That is, overshooting above the fair value (72-73 in our view) could also be acceptable unless it becomes a serious threat to inflation. Given that oil is the most important driver at the moment for the exchange rate, we await to get further clarity about the oil market (Iran sanctions, increase in supply from OPEC etc.) and investors’ behavior in response to today’s monetary policy decision before we change our call.
• On the bond yields, the downside movement is likely to be limited because of the change in the stance of the RBI. If the rupee depreciates further, the RBI will have to hike interest rates to control imported inflation. While that’s not a done deal yet, element of uncertainty around rupee and oil prices could keep the bond investors edgy. Thus, we stick with our year-end call of 8.2% for the benchmark 10-year yield.

*Mr. Abheek Barua, Chief Economist, HDFC Bank. Mr. Barua tweets at @AbheekHDFCBank.