RBI cut the Repo Rate by 25bps in its Bi Monthly Policy Review today, on the 2nd of June 2015, taking the rate to 7.25%. This cut is the third in calendar 2015, taking cumulative cuts to 75bps. However, the Central Bank is non-committal on future rate actions and has actually projected an upside risk to inflation on the back of below normal monsoons and hike in service tax to 14% from 12.36%.
CPI inflation is projected at 6% as of January 2016 from earlier projections of 5.5%. CPI at 6% in January 2016 is at RBI’s target but given that inflation is not likely to undershoot the target, further monetary easing is in doubt.
RBI’s tone today was a reluctant cut. A rate cut of 25bps was warranted on headline inflation moving on a projected path, unseasonal rains having limited impact on prices, no increase in administered prices and Fed pushing back rate hikes to the second half of the year. However the case for holding policy rates status quo was well highlighted, right from effects of EL Nino to oil prices rising from lows and weak export growth leading to forecast of a CAD (Current Account Deficit) coming in higher than that of last year.
Markets sold off post rate cut on the back of expectations of RBI holding rates status quo for the rest of this fiscal year. The ten year benchmark bond the 7.40% 2025 bond saw yields rising 6bps from lows of 7.63% to 7.69% post policy. Sensex and Nifty are trading around 0.5% down from pre policy levels. The INR fell marginally from Rs 63.70 to Rs 63.84 post policy.
What can the markets expect going forward? The bond market will be wary of below normal monsoons and the government’s reaction to the monsoons. Efficiency in distributing food grains and timely imports of essential food products will keep down inflation expectations. Bond market will also be watching global bond yields that have seen volatility last month. Read our report on Global Bond Yield Volatility. Fed rate hike is always looming ahead.
The economy is not showing robust health, which was one of the reasons for the rate cut today. Export growth is negative, Rural demand is weak and can weaken further on poor monsoons, corporate results have been muted (Read our Report on Corporate Performance), core industries output declined in April and bank credit growth is still weak at around 10.15% levels.
Global demand is weak as seen by weakness in export growth. Sensex and Nifty will struggle in the short term given various headwinds.
The broad strength of the USD that is up over 15% against majors is likely to pull down the INR though the currency is unlikely to see sharp falls given that CAD is highly manageable at levels of 1.5% of GDP and RBI building fx reserves as an insurance against global market volatility. Fx reserves at USD 350 billion are at record highs.
Medium term outlook is still positive
In the short term, markets will struggle to give returns but going forward, outlook is positive. On the domestic front, introduction of GST in April 2016 will improve the fiscal position of the government. Liquidity is comfortable in the system given RBI fx purchases of USD 57 billion last fiscal year and continued purchases expected in this fiscal year. CPI inflation is likely to stay down on the back of weak global commodity prices Table 1. Oil prices are unlikely to trend much higher from levels of USD 65/bbl given that the US is likely to become an oil exporter by 2018. Read our note on Commodity Index and Oil Production.
Interest rates and liquidity globally will be low and easy respectively as ECB and Bank of Japan pump in money at close to 0% rates to provide stimulus to their economies. US economy is likely to grow at a moderate pace according to the Fed enabling the Central Bank to adopt a gradual normalization of policy.
Easy domestic liquidity and falling lending rates as banks pass on rate cuts to the consumer will help in driving domestic demand.
Corporate performance will pick up going forward and that will drive equities higher. Improved government finances and inflation expectations being kept down will help lower bond yields.