Interest rates hardened sharply during the month as significantly higher than expected April’s Consumer Price Index (CPI) inflation came in at 7.79%. Further, elevated inflationary pressures led by global commodity price surge prompted RBI to go for a pre-emptive strike on inflation by undertaking off cycle repo rate hike of 40 basis points (bps) in May 2022 and subsequently by 50 bps in June policy review taking the repo rate to 4.90%. RBI had also increased the Cash Reserve Ratio (CRR) by 50 bps to 4.50% in May 2022, thereby withdrawing liquidity of Rs. 870 billion from the system.
With these moves, RBI has shifted its focus from growth supporting to inflation controlling policy and justified that the rate hikes were undertaken to anchor inflation and inflation expectations, which had changed rapidly post the Russian Ukraine crisis. The MPC minutes of May meeting, and June policy review clearly highlighted the concerns on inflation breaching the upper band of 6% and reflects the intent of MPC to continue with its focus on taming inflation till inflation comes within the targeted range of 2% to 6%.
As spiraling inflation remained a key concern, the government also stepped-up its efforts to help tame the inflation. The government slashed fuel taxes on petrol and diesel, which will lead to reduction in inflation by 20 bps directly and 50 bps indirectly. Further, it announced an additional fertilizer subsidy of Rs. 1.10 lakh crores to cushion input costs to the farmer. Together, these subsidies would lead to revenue loss of ~0.80% of GDP.
While the conservative budget estimates on the revenue side will help offset some bit of the revenue loss by the government on account of subsidies announced, still the fiscal estimates may move up marginally by 0.20% of GDP, which in turn may translate to increase in gross market borrowing by Rs. 1.50 trillion.
Given the increased focus on controlling inflation, rapid move up in normalizing the policy rates to pre-pandemic levels and higher than expected market borrowing, bond yields have hardened considerably. The bond yields moved up sharply in May with 1 year to 3 years AAA corporate bonds yields seeing an uptick of ~80-100 bps, the 5-year segment yields rose by ~60 bps and 10-year yields went up by ~37 bps. The 10-year government security moved up by 28 basis points to close at 7.42% on the month end.
Outlook
In CY 22, globally inflation has taken centre stage, compounded by the Russian Ukraine crisis. We believe that inflation trajectory is uncertain and would remain elevated throughout the year. Global factors which could impact the inflation trajectory include geopolitical uncertainties emanating from Ukraine-Russia crisis, quantum of rate hikes by US Federal Reserve, elevated commodity prices driven by high energy prices, etc. On the domestic front, the persistently high food prices pose an upward risk to inflation.
With these challenges surrounding the global economies, many Central Banks will continue to tighten the monetary policies to tame inflationary pressures.
In India, at the current juncture, our view is that RBI is likely to move towards a repo rate of 5.75% to 6.00% by April 2023 from the current 4.90%. However, the question which is unanswered is whether this would be the terminal repo rate. On inflation, the consensus view is that the average inflation would be around 6.50%-7.00% in FY 2023; however, the inflation trajectory going into FY24 remains uncertain. We would look at the incoming data on various global and domestic factors highlighted to understand inflation trajectory in FY24 along with RBI’s monetary policy stance to determine the terminal repo rate.
With a huge fiscal supply and RBI’s expected fast withdrawal of ultra-accommodative policy, we expect interest rates to remain volatile with an upward bias till a consensus on terminal rates comes.
We feel that 6 months to 1 year segment of the yield curve provides an opportunity to risk-averse investors amidst expectations of repo rate hike going forward. Given that 1Y to 3Y rates are significantly higher pricing more rate hikes going forward. For investors looking at the core allocation, the 1 to 3 years segment of the yield curve remains well placed from carry perspective. Hence for us, the sweet spot remains the short end of the yield curve which stands to benefit from the absolute level of relatively high yields, while not getting impacted by the rate volatility, in comparison to the longer end of the curve.
While credit environment is expected to continue improving over the medium term, current extremely narrow spreads of AA / AA+ over AAA bonds do not provide favorable risk adjusted reward opportunities, and we expect liquidity premium to increase sharply over a period of time thereby posing mark to market challenges for this segment.