RBI against all expectations kept policy rates unchanged in its two day policy meet that ended today, the 7th of December 2016. Markets were expecting a 25bps to 50bps rate cut and have since reacted negatively to the policy decision. Ten year gsec yields rose 13bps post policy while Sensex & Nifty fell by 1%. INR stayed flat.
The outlook for bonds is a steepening yield curve where liquidity will keep short end rates stable while long end search for direction. Sensex & Nifty will stay ranged as markets sway between global equity rally and short term fall in GDP growth. The INR will take direction from broad USD movements. Read our note on USD.
The next driver for markets is the US Fed rate action next week, which is largely expected to be a 25bps rate hike. Fed guidance on inflation and growth will determine the pace of rate hikes going forward.
Positives for the market going forward are a fiscal boost to the government from demonetisation, good system liquidity and stable policy rates with a bias towards cuts if long term inflation expectations fall on demonetization.
Why Status Quo on Rates?
RBI showed high prudence in its policy today, looking at the effects of demonetization on inflation and growth as transitory. On inflation, RBI estimates that demonetization will have around 10bps to 15bps effect on CPI while on growth it has revised GDP growth from 7.6% to 7.1% for fiscal 2016-17. Growth effect of demonetization is expected to last a couple of quarters.
RBI is wary of the volatility in global financial markets that could be caused by Fed rate hikes, issues in the Eurozone, oil price rise on OPEC production cuts and geo political issues in the middle east. A status quo on rates is the best decision at the moment according to RBI.
On liquidity, RBI has stated that system liquidity turned to surplus in November, before demonetization was announced and it has achieved its aim of taking system liquidity from deficit to neutral territory. RBI will not be conducting any OMO operations after having bought Rs 1100 billlion so far this fiscal year.
Repo rate at 6.25% signifies a real rate of interest of 1.25% over March 2017 CPI inflation expectation of 5%. RBI is worried about stickiness in core inflation at around 5% levels and given that RBI has an inflation target of 4% +/- 2%, rates were kept on hold.