As was widely expected, the Reserve of India (RBI) in its fifth bi-monthly policy review on Tuesday, left key policy rates unchanged. But it hinted that a rate cut may happen early next year. “If the current inflation momentum and changes in inflationary expectations continue, and fiscal developments are encouraging, a change in the monetary policy stance is likely early next year, including outside the policy review cycle,” RBI said in its statement. Inflation based on consumer price index for October came in at 5.52% compared with 6.46% in the previous month.
The rate cut
Inflation has come down on the back of softening global commodity prices, including crude oil, which has fallen over 35% since the beginning of the year and 24% since the previous policy review. It is being speculated in the international market that it could fall to the level of $40 per barrel compared with present level of about $71. Therefore, if the overall disinflation continues, the rate cut will come in early next year. “The rate cut will happen in March,” said Indranil Pan, chief economist, Kotak Mahindra Bank Ltd, adding that by February (when the next policy review is scheduled), RBI would have inflation data till January, and would like to consider the February data and see the Union Budget before taking a call.
“Given the RBI’s focus on fiscal developments as an initial condition, it is likely to watch the budget end-February closely. As such, we expect no change at the next policy meeting either (3 February) and a possible cut in April (compared to our earlier expectation of rate cuts starting in June),” stated a post-policy note from Nomura. “We continue to expect a total of 50bp (basis point) of cuts in 2015, with rates remaining on hold thereafter,” it added. One basis point is one-hundredth of a percentage point.
The market is expecting inflation to soften, and rates have actually come down a fair bit. For example, yield on the 10-year government bond has come down over 50 bps since the previous policy review on 30 September.
In the stock market
The impact of softening inflation, falling crude oil prices and expectation of a rate cut is already showing in the stock market. S&P BSE Sensex is up about 7% since the last policy review and rate sensitive sectors such as the BSE Bankex is up over 20%. Ajay Bodke, head (investment strategy and advisory), Prabhudas Lilladher Pvt. Ltd said that since the rate cut has not happened, the markets will consolidate and not fall because of strong inflows. He is also of the view that the RBI would like to see the quality of fiscal consolation before cutting rates.
Deposit and lending
In the monetary policy document, the RBI stated that liquidity conditions have eased considerably in the third quarter of 2014-15 and deposit mobilization has outpaced credit growth. As a result, major banks such as State Bank of India, Bank of Baroda, Andhra Bank, Central Bank of India and ICICI Bank Ltd, have cut deposit rates in the past two months.
Will the deposit rates fall further? “Banks have been reducing rates in certain deposit baskets. Currently, the one-year deposit rates are 8.8-9%. Further reduction is possible but with a lag of a month or two. Also, it’s unlikely that the rates will fall below 8.5% considering that other government schemes offer returns at that level,” said Vishal Narnolia, banking analyst, SMC Global Securities Ltd.
So, should you invest in fixed deposits (FDs) at this point? “If you are an investor who only opts for FD, this is the time to lock in your money as there are expectations of a further deposit rate cut in a couple of months,” said Surya Bhatia, a Delhi-based financial planner.
RBI also stated that the weak transmission by banks of the recent fall in money market rates into lending rates suggests monetary policy shifts will primarily have a signalling effect for a while. “RBI has noted that the recent easing of monetary conditions has not translated into lower bank lending rates. The most important aspect is that the policy rate remains unchanged and, therefore, there is no clear view so far on the sustainability of easy monetary conditions,” said Roopesh Pathania, managing director and head of trading-India, Malaysia, Thailand, RBS.
Banks, however, have not given any indication of reducing lending rates in the near term. If you were looking for relief on your equated monthly instalments, a cut may be on its way early next year.
What if you want to borrow? “You stand to gain if you take floating rate loans. Completely avoid fixed rate loans. It’s expected that the lending rate may come down in the next one-two quarters, and the only way to make the most of it would be to take a floating rate loan,” said Bhatia.
Debt funds
Since there is a good chance that the interest rates will come down, should fixed income investors look at debt funds? “The timing of the rate cut should not matter much as there is now a clear direction for the market. This has already been the case with G-Sec yields, which fell 60-70 bps in the past six months,” said Vidya Bala, head-mutual funds research, FundsIndia.com. “Rates cuts, when they happen, would be measured—and not in large portions at a time—but consistent. Current gentle slide in yields, along with a measured cut, would prevent speculative exits in the bond market, thus leaving more money on the table for long-term investors,” she added.
So what kind of funds should investors have in their investment portfolio? “Investors should look at long duration funds at this time,” said R. Sivakumar, head (fixed income), Axis Asset Management Co. Ltd, adding that when the RBI actually cuts rates, it will maintain that stance for a while. “We have been advocating investors with a two-year-plus view to go for income funds that have a mix of government securities and corporate bonds. While pure gilt holdings could be risky for retail investors as these require an active profit booking strategy, income or dynamic bond funds that have upped their portfolio maturity and also hold some good corporate bonds with profitable spreads should deliver adequate returns without too much risk,” said Bala.
Mint Money take
RBI refrained from cutting rates but indicated that policy accommodation might start early next year if inflation continues to soften. While rates in the market have already come down, a policy rate cut will boost sentiment and enhance confidence regarding the trajectory of interest rates. Deposit and lending rates may also come down in the near term, though it is difficult gauge the timing and quantum at this stage.
Stocks are likely to remain buoyant on the back of flows and expectation of a turnaround in economic activity. However, many of the assumptions that the market is working with will be tested in the budget.
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