RBI, while holding on to policy rates in its 2nd December 2014 policy review, has guided markets towards a change in policy stance from neutral to accommodative. The central bank wants to be sure of inflation being anchored before it cuts the Repo Rate from current levels of 8%. RBI had last raised the Repo Rate by 25bps in its January 2014 policy review.
The market reaction to the policy review says it all. The benchmark ten year government bond, the 8.40% 2024 bond initially rose 3bps to levels of 8.10% on disappointment of no rate cuts but then fell all the way back to 8.01% as markets read the policy as dovish. 8.40% 2024 will trend lower in the coming days as markets position for a series of rate cuts starting February 2015 or even earlier.
Dr. Raghuram Rajan in his policy statement has highlighted the fact that global economic growth is weak barring the US and India is yet to see growth factors firing with weak Q2 2014-15 GDP nos. Read our analysis on Q2 GDP 2014-15 GDP by Economic Activity and by Expenditure.
The central bank is slightly wary of the government meeting its fiscal deficit target of 4.1% of GDP for this year due to weak tax revenue growth but emphasized the fact that the government is keen on sticking to its target. Net Direct Tax collection has grown by just 7% in the April-September 2014 period from full year target of 19% while Indirect Tax collection has grown by just 5% in the April-October 2014 period from budgeted levels of 19%.
On the inflation front, RBI is more confident of achieving its 6% CPI target for January 2016. The fact that global demand is weak, commodity prices are down and disinflationary pressures are gaining ground globally gives confidence to the RBI on controlling inflation expectations.
The only reason RBI did not cut the Repo Rate today given its highly dovish stance was to be doubly sure that all factors are going in its favour when it turns policy to accommodative from neutral. It does not want to reverse its policy stance when it changes it.
RBI will most probably cut the Repo Rate in its 3rd February 2015 policy review but cuts could come in sooner if inflation falls well below target in January. Base effect is highly favourable for inflation coming off “Read our economic data analysis for Inflation analysis” in the next month but given an overall lack of inflation drivers except monsoons, that are unpredictable, RBI is not too concerned on the inflation front at this juncture.
Liquidity has become easy in the system on government spending and fx purchases by the RBI. Read our Liquidity Cheat Sheet for Liquidity analysis. RBI is selling bonds to suck out system liquidity in order to maintain overnight rates at close to Repo Rate levels of 8%. Liquidity is structurally positive and this would drive down money market securities yields further.
Bond and equity markets will factor in a series of rate cuts starting 2015 and that should drive down bond yields and drive up equity valuations. The risk to bonds is in the form of the government being unable to stick to fiscal deficit targets while risk to equity is in the form of global economic growth weakening. The INR has held its own against a strengthening USD on the back of improved macro economic environment. Read our Analysis, Why INR will hold its own despite and broad USD strength. Global risk aversion is the key risk for INR.