Money market rates will move in a 7.75% to 8.75% range over the next couple of months and this will align government bond, corporate bond and interest rate swap curves accordingly. Bond markets will factor in one more 25bps rate hike in December or January but will also look at repo rate of 8% being the normal operational rate. Bond and swap yields at the short end of the curve will trend down while yields at the longer end of the curve will stay stable given the interest rate outlook.
RBI delivered as per market expectations in its 29th October 2013 policy review. The central bank hiked the repo rate by 25bps from 7.5% to 7.75% on the back of the WPI (Wholesale Price Index) and CPI (Consumer Price Index) averaging 8.5% and 9.5% over the last three and five years respectively. RBI normalized the spread between repo rate and MSF (Marginal Standing Facility) to 100bps by lowering the MSF rate by 25bps.
The central bank did not remove restrictions on LAF (Liquidity Adjustment Facility) access for banks that is pegged at 0.5% of NDTL (Net Demand and Time Liabilities). However the central bank increased the term repo access for banks to 0.5% of NDTL from 0.25% of NDTL.
Banks are borrowing Rs 40,000 crores in LAF at repo rates of 7.75%, Rs 19,500 crores in term repo at around 30bps below MSF rates and Rs 18,000 crores in MSF (as of 28th October 2013). The higher limit for banks access to term repo will enable banks to access around Rs 40,000 crores of funds in term repo auctions. If system liquidity is within an Rs 80,000 crores deficit, money market rates will move in a 7.75% to 8.75% range.
Growth concerns have prompted the central bank to balance out liquidity requirements at reasonable rates for the system while lowering long term inflation expectations. RBI has lowered its GDP growth estimates for the economy from levels of 5.5% to levels of 4.8% for fiscal 2013-14. Growth is trending at decade lows and all growth drivers are muted with business confidence low, private final consumption expenditure down and corporate investment intentions coming off.
The INR has behaved itself in October 2013 by moving in a narrow Rs 61 to Rs 63 range. The Fed is expected to maintain the size of its asset purchase program well into the first quarter of 2014 on concerns over the government’s inability to reach a full agreement on budget and debt ceiling. The INR is a direct beneficiary of the Fed’s asset purchases. The INR is also likely to benefit from a lower CAD (Current Account Deficit) for the second quarter of 2013-14 given sharp fall of 40% in trade deficit quarter on quarter on the back of 70% fall in gold and silver imports.
Food prices coming off is a strong possibility given above normal south east monsoons and withdrawal of cyclonic conditions in the east coast of India. Lower food prices, stable INR and below trend GDP growth rates (implying negative output gap) could bring down inflation expectations but the key to lower long term inflation expectations is governments policies on subsidy and fiscal deficits. In an election year, RBI will not have much hope for reforms from the government on the subsidy front. Hence, the central bank would rather play the liquidity corridor than use interest rates as a policy tool going forward.
