The Global backdrop turned challenging during the month, with many data points in the US like the jobs market, core inflation, & personal consumption expenditure pointing towards the need for higher policy rates and a delayed rate cut cycle than earlier expected. Various US FOMC members have also hinted towards a data-driven approach, making the next readings on inflation and jobs data very critical for rate trajectory. USD gained strength with expectations of tighter monetary policy. Global markets reacted negatively, with most of the developed nations witnessing a 40–50 bps rate hardening (10 yr G-Sec benchmark) with the shorter end coming under more pressure. Emerging nations also witnessed a hardening of rates, though to a lesser extent.
Domestically also, interest rates remained under pressure and G-Sec hardened by 15-30 bps across the curve, with the short end coming more under pressure rendering almost a flat yield curve. Corporate bonds also hardened, though to a lesser extent.
MPC moderated the rate hike to 25 bps to reach 6.5% as the repo policy rate but continued to maintain its “withdrawal of accommodation” stance. MPC’s more hawkish commentary on domestic inflation surprised the market negatively, thereby leaving the market guessing for the next policy action which was earlier positioned for 6.5% as the peak policy rate.
Headline CPI inflation in January surprised on the higher side with a 3-month high print of 6.5% y-o-y, sharply up from 5.7% in the previous month, led by both food at 6.2% YoY and core at 6.3% YoY. In sequential terms, the headline index rose by 1.1% m-o-m vs. 0.5% previously.
FPIs remained net equity sellers again in February, though marginally, a with an outflow of ~INR 54 bn. Debt segment saw a marginal inflow of ~INR 21 bn. Fx reserves at week ending 24th Feb were USD 561 bn, down USD 16 bn from end of Jan 2023. INR depreciated by ~0.9% during the month as the USD gained strength, but still remained relatively better as compared to other EM currencies.
Outlook
MPC’s hawkish commentary on inflation concerns and resilient domestic growth, the subsequent elevated inflation print, and the sharp change in the global backdrop have raised the probability of one more rate hike in the next meeting in April 2023 (from almost nil earlier). While the debate on the peak policy rate is still on, we believe MPC’s next policy action would be more data dependent and largely driven by the monetary policy action of other Global Central Banks especially the US FOMC. We also believe that India will see the policy rates remaining “Higher for Longer” as domestic growth-inflation dynamics may not provide any room for rate cuts in 2023, even if the Global Central Banks were to start their rate cuts in 2023 to address their country specific growth concerns.
As central banks reach to the peak policy rates over the next few months, markets have already factored in the next rate hikes to a large extent. With Central banks steering towards the end of the rate hike cycle and lesser uncertainty on fiscal supply for now, we believe the Indian fixed income market has come to an inflection point with risk-reward turning favourable for investors with already elevated yields, especially upto 5-year segment. Longer end may somewhat remain under pressure as the fiscal supply overhang continues for next year as well.
The credit environment remains healthy, however, current narrow spreads of AA / AA+ over AAA bonds do not provide favorable risk adjusted reward opportunities, and we expect the illiquidity premium to increase sharply over a period of time, thereby posing mark to market challenges for this segment.