The RBI cut the Repo rate by 25bps today as it has gained confidence that inflation expectations are well anchored. The central bank in its policy review in December 2014 had stated that it would consider rate cuts outside of 3rd February policy review if it believed that inflation expectations were on its desired path.
The markets were factoring in a 25bps rate cut in February but the cut effected on the morning of 15th January before market hours was a first. Ten year benchmark bond yields dropped 11bps while one and five year OIS yields were down by 9bps and 5bps respectively.
The 25bps repo rate cut effected today is a precursor to more rate cuts ahead and the first one could come as early as RBI’s bi monthly policy review on the 3rd of February. RBI Governor Dr. Raghuram Rajan had clearly stated that the central bank once it cuts rates has shifted its stance to accommodative. RBI took time to cut rates in the face of weakening growth and falling inflation as it wanted to clearly shift its stance and not change stance with short term data points.
Rate cuts aside, RBI will have to actively manage liquidity in the system that is likely to become extremely tight by end March 2015. Banks cannot pass on rate cuts if liquidity is tight in the system. RBI is managing liquidity through term repos and may consider OMO purchases if liquidity starts straining the system. Read our analysis “Liquidity Deficit will Touch Rs 2000 billion in March”.
Government bond yields will continue to trend down on rate cut expectations but tight liquidity conditions will keep money market securities yields at higher levels and credit spreads will tend to rise. OIS markets have factored in at least 100bps rate cuts as five year OIS yields are at 6.90% levels. The five over one OIS yield spread will tend to flatten as RBI cuts rates.