The highly negative market reaction to RBI 2nd June 2015 25bps Repo Rate cut gives rise to the question of the efficacy of RBI policy. Repo rate cut is expected to bring down cost of funds in the system that will eventually filter into the economy either directly through lower lending rates or indirectly through lower government bond and corporate bond yields, at least at the short end of the yield curve.
Sensex and Nifty fell 2.35% each post rate cut while government bond yields rose 6bps to 10bps across the yield curve. The negative reaction to the rate cut was on the back of the “What Next” factor where markets do not have anything positive to look forward to in the near term and chooses to sell equities and bonds. Read our RBI Policy Analysis “ Markets have nothing to look forward to in the short term”.
Should you invest in equities and bonds in this market fall? First let us look at the risk to your investments. The known negatives in the market are below normal monsoons, Fed rate hikes and lack of demand in the economy as seen by muted corporate results for the last two quarters, weak bank credit growth and uneven growth seen in the IIP (Index of Industrial Production). The risks are negated to some extent by the fact that the country had record foodgrain production over the last three years and stock of foodgrains is enough to see the country over a monsoon failure. The government can always import agricultural products to ease supply pressures as the country is benefitting from low global oil prices that is keeping CAD (Current Account Deficit) in check at around 1.5% of GDP. Fast and efficient government measures on poor rainfall will keep down prices of food products and keep down inflation expectations.
The Fed is expected to start hiking rates starting September 2015 and markets suggest that at the end of 2016, Fed funds rate would be around 1.25% to 1.5% from 0% to 0.25% levels as of now. Given that the spread between Fed Funds rate and RBI Repo rate is at 7%, there is enough cushion for the spread to contract even after the Fed hikes rates. The worry about money flowing out of India back to US treasuries will come true only if there is a huge risk aversion caused by global financial markets crisis and not by Fed rate hikes.
The reason RBI cut the Repo Rate was to spur demand in the economy through cheaper borrowing costs. Banks have been reluctant to pass on borrowing costs to the consumer given high non performing assets levels (NPA’s plus Restructured Assets is at over 10% of Gross Advances). However liquidity is good in the system with RBI adding over Rs 3.4 trillion through USD purchases in the last fiscal. Fall in overnight money market rates to 7.25% levels, which is the new Repo Rate, from 7.5% levels prior to rate cut, will help banks to cut deposit rates. Banks can steadily grow credit given easy liquidity and lower rates and that will improve demand in the economy.
RBI has guided for a period of no rate actions, at least until January 2016 where it expects CPI inflation at its target levels of 6%, taking into account weak monsoons and other unexpected threats to inflation in the form of higher global commodity prices. Given stable Repo Rate and easy liquidity conditions, bond yields should stay stable with the market being comfortable in earning the spread between Repo Rate at 7.25% and Government and Corporate bond yields at levels of 7.70% to 7.90% and 8.3% to 8.5% respectively. Borrowing costs for both government and corporates are likely to be stable.
The short term negative reaction of the market to the RBI rate cut is giving an opportunity for you to buy into equities and bonds/ bond funds. However you should be able to ride out volatility and have a holding period of at least three years for the best returns to filter into your portfolio.