RBI delivered a positive surprise to the markets with a 50bps repo rate cut. Markets were expecting a 25bps repo rate cut and have reacted positively to the 50bps rate cut with equities up, bond yields down and the rupee flat. The Sensex and Nifty are trading higher by over 0.5% post policy announcement while the ten year benchmark bond yield is down 10bps. The question is will the positive momentum sustain on the back of rate cuts or will markets turn cautious on a neutral guidance by RBI on further rate cuts?
Markets will take a while to digest the 50bps rate cut as the RBI has delivered a positive surprise to the markets after two years (since the time the RBI started tightening policy rates). The negatives of a fresh surge of over 100bps in bond yields of indebted countries such as Spain and Italy are weighing on the Sensex and Nifty, which have come off by 7% from highs seen two months back. Bond yields are grappling with a heavy government borrowing of Rs 370,000 crores for first half of fiscal 2012-13 and are up by 20bps over the last two months.
In the near term markets will weigh the positives of RBI rate cut and negatives of Eurozone issues and government borrowing and trade in a range. In the medium term, equity markets will turn positive on expectations of global economy showing resilience with US leading the way with steady job growth (over 1.2 million jobs added in the last seven months) and growing retail sales (retail sales have beaten expectations in February and March). Bond markets will turn positive on the back of rate cuts and improving liquidity situation helping the market absorb government borrowing. In the medium term the Sensex and Nifty will trend back above 18000 and 5500 respectively from current levels of 17,200 and 5250 while bond yields will trend down to 8% levels from current levels of 8.4%.
The 50bps rate cut brings down the overnight rate to 8% from 8.5%. RBI has allowed banks to borrow 2% below SLR (Statutory Liquidity Ratio) from the MSF (Marginal Standing Facility) window at 9%. Banks are running SLR of around 29% against a statutory limit of 24% and the system will not be constrained for liquidity as banks can technically borrow around 7% of NDTL (Net Demand and Time Liabilities) by using their holdings of government bonds. Banks can effectively borrow over Rs 400,000 crores from the RBI at levels of 8% (repo) and 9% (MSF).
The availability of higher liquidity for banks at lower yields of 50bps post rate cut will bring down money market securities rates. Three month and one year CD (Certificate of Deposit) rates will come off by 100bps from levels of 9.5% and 9.9% respectively. Corporate bond yields at 9.4% for five and ten year benchmark AAA bond will come off on the back of easing liquidity concerns and lower policy rates. Five and ten year corporate bond yields will trend down to below 9% levels in the next couple of months.
The OIS (Overnight Index Swap) curve will remain steady at current levels of 7.95% on the one year OIS and 7.45% on the five year OIS. The fact that RBI has not explicitly indicated further rate cuts ahead will keep one year yields around repo rate levels of 8%. Five year OIS yields, which are 100bps below five year government bond yields will struggle to trend down without indications of further rate cuts ahead.
The Rupee is not likely to move up against the US Dollar in the near term on worries of high current account deficit of around 3.6% of GDP. However given an expected rise in equity markets in the medium term leading to higher FII flows, the Rupee will trend higher to levels of Rs 48 to the US Dollar from current levels of Rs 51.60.