RBI monetary policy: ‘We expect rates to be on hold through 2018’

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We believe the market went into the policy meeting expecting a neutral to hawkish tone. Overall, we expect rates markets to consolidate around current levels. We do not expect any further open market operation sales and expect banking system liquidity to reach neutral conditions by fiscal year-end.

The policy outcome was largely in line with expectations. Although there could be some downside risk to the Reserve Bank of India’s (RBI) FY18 gross value added (GVA) growth projection, we believe that growth is headed higher, supported by ongoing remonetisation, resolution of goods and services tax (GST)-related issues and large bank recapitalisation. Meanwhile, risks to near-term inflation have risen on higher oil prices and rising vegetable prices, while the cobweb cycle (adverse supply response to low food prices in H1 2017) and higher growth are medium-term risks.

Overall, we believe that both growth and inflation are headed higher, but we expect rates to be on hold through 2018 as the RBI has a sufficient real rate cushion to absorb higher inflation. The hawkish signal from the RBI’s policy statement was the 10-basis point (bp) rise in its inflation forecast to 4.3%-4.7% (for Q3 and Q4 FY18), but the fact that one member of monetary policy committee (MPC) voted for a rate cut suggests that there has been no change in view from the doves. Overall, external conditions have deteriorated recently with the sell-off in equities adding to pressure on rupee and this remains a major market near-term focus. That said, it remains to be seen whether this risk-off environment persists, and as such we add a short-dated hedge to our portfolio. Our base case is still for a continuation of the supportive emerging market (EM) backdrop into 2018. Notwithstanding the global backdrop, we remain constructive on rupee, due in part to a credible monetary policy, recovering growth and still-strong balance of payments position with large foreign exchange (FX) reserves. In the near term, we see a positive outcome from the Gujarat elections as a potential catalyst for rupee strength while RBI dollar-buying intervention could be constrained by increased focus from the US Treasury.

We believe the market went into the policy meeting expecting a neutral to hawkish tone. Overall, we expect rates markets to consolidate around current levels. We do not expect any further open market operation sales and expect banking system liquidity to reach neutral conditions by fiscal year-end. For rates markets, and especially bond performance, focus will shift to fiscal news and commodity prices.

Sonal Varma

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