Consolidation Phase for Debt Market

June 2, 2015 . Vidya Bala

rbiA 25-basis point cut in repo rate to 7.25 per cent in today’s Monetary Policy review, totals to a front-loaded 75 basis point cut thus far in 2015. Further action, as the Governor of the Reserve Bank of India (RBI) stated, would be ‘data contingent’.

The 7.72% 2025 gilt remained almost flat at 7.66 per cent, suggesting that the market was not thrilled, nor was it reacting negatively to the marginal upping of the inflation forecast to 6 per cent by January 2016.

It is evident that the RBI is fearing a risk of inflation arising from the following factors:

– Below normal south-west monsoon forecast by the Indian Monsoon Department, having an impact on food inflation
– Any further firming of crude prices that can fuel inflation and demand for the dollar
– Volatility in external environment – both political and economic

While the RBI has stated that any further rate cuts will be data contingent, its desire to maintain real rate (interest rate in excess of inflation) at 1.5-2 per cent may mean that the RBI has cut rates more than it would ideally like to (given that it expects a 6 per cent inflation by January 2016).

However, one needs to look at a slightly longer period inflation target of 4 per cent target by early 2018. Even at an average of 5 per cent (between 4 per cent and 6 per cent), we believe that there is leeway for further cuts, albeit not immediately. That means, opportunities are still alive in the yield curve, inflation not playing spoilsport.

What’s in it for investors?

The current rate cut cannot be expected to bring about an immediate rally in the market. Between February and now, long-term debt yields have crept up marginally despite three rate cuts of 25 basis points each. It is noteworthy that the depreciating rupee against the dollar, firming crude prices, and foreign debt market (especially Germany) yields firming up have all kept the local yields from easing down.

For investors, this means that the opportunity in the yield curve is only consolidating and remains there. In other words, an opportunity for rally remains. However, this would require an easing of yields driven by macro numbers such as inflation and a normal monsoon.

Investors should continue to hold income accrual / dynamic bond funds, but not expect any short-term returns from these funds for now. Short-term rates can be expected to continue to ease unless there is a liquidity issue, or inflation firms up. To this extent, the opportunity in medium to long term debt funds remains better than short-term funds at present. Besides, the fact that deposit rates have eased and may further reduce also means that one has to scout for investment opportunities outside of bank deposits.