MPC pauses, is likely done: Monetary Policy Review April 2023

NEW DELHI: Against majority expectation, MPC paused on rate hikes in a unanimous decision. All except RBI MPC member Prof. Jayanth Varma chose to persist with 'withdrawal of accommodation', with the latter presumably wanting to shift to neutral in light of his view that repo rate should have peaked earlier. The bond market is justifiably celebrating with this being the final green light, so to speak, in what was already turning into a benign global environment for rates.

Assessment

While choosing not to hike today, the Governor (on behalf of MPC majority) has also made it a point to underscore that this may not necessarily be the end of the cycle.

He notes the improvement in our external situation (current account deficit compressing and forex reserves built back to higher than USD 600 billion), the prospects of inflation falling ahead (RBI forecast for FY 24 10 bps lower at 5.2 per cent), and drag from the external sector on growth (though GDP forecast for FY 24 is a shade higher now). Nevertheless, core inflation is sticky, there has been a recent upside surprise from food inflation, and risks to this persist from climatic conditions.

All told the MPC majority may have been inclined to deliver a last 'insurance ' hike had global conditions remained as they were till a few weeks back. However the recent issues with US regional banks and a large European one, and the consequent actual and expected tightening in credit conditions, have changed the mix materially.

The upshot is that this has significantly altered the market's expectation of the Fed fund's trajectory basis the expected impact on growth from the said credit tightening. There's an element of financial stability consideration as well that may be creeping back into global monetary policy decision making even as the backdrop remains one of uncomfortably high inflation. This has led to central banks letting off on incremental tightening somewhat, even as the propensity is for the foot to still be hovering in the vicinity of the brake.

RBI / MPC's own trade-offs are more moderate. India's growth, though slowing, is not likely to fall off a cliff. Inflation, though uncomfortable today, is within shouting distance of the comfort zone. However, global considerations for the last incremental hike seem legitimate and MPC has rightly considered these in its decision making. Also, the cumulative effective hikes of 290 bps are still feeding into the system. The pause (not pivot, as the Governor has specified) firmly keeps the anchor of inflation in mind. With stance remaining 'withdrawal of accommodation' it seems the bias with the majority members is still to consider another hike.

Interpretation & Takeaways

The above said, we think the rate cycle has peaked in India. It is likely that we are now in a period of long pause, unless there are near term further upward surprises to inflation. To elaborate upon this qualifier, we are reasonably confident that no further hikes are needed if one were to look at the likely evolution of growth-inflation dynamics over the next 6 - 12 months.

Tighter credit conditions in the west will lead to weaker than earlier anticipated growth. This will continue to feed into India's growth dynamics as well, alongside the cumulative impact of tightening done so far that is yet to be fully felt.

With India having avoided any extra-ordinarily large fiscal stimulus over the Covid response period, it isn't apparent why cyclical demand should stay as strong as it is currently (structural tailwinds are well documented including from balance sheet cleanups in India). For these reasons, we expect growth to be substantially shy of RBI's current forecast for FY 24.

If there are further upside manifestations to inflation in the immediate future, before the factors mentioned here have played out, then the last rate hike may very well come back on the table. However, this will eventually be splitting hair for medium term bond investors. As mentioned multiple times before, we think investors should be overweight quality bonds in both a fixed income as well as a multi asset allocation context.

The recent fly in the ointment, so to speak, is that post tax returns on traditional fixed income allocations via mutual funds have fallen for allocations starting the new fiscal year. This has already started conversations on adding risk in asset allocation tables including from credit, liquidity, and from other asset classes. This is partly understandable given that post tax yield on quality fixed income is going to be noticeably lower than before.

However, there are two points of caution: One, the reach for 'return / yields' during such periods fundamentally implies a framework where appetite for risk is variable but return expectation is static. Whereas the decision to take more risk should consider the natural underlying risk appetite as well as a view on the macro-economic backdrop and whether this supports the incremental expansion of risk appetite. While the former is a matter of individual assessment, our view on the macro-economic evolution over the next few quarters isn't consistent with adding on more risk (outside of interest rate risk). As an example spreads on lower rated credits, generally speaking, are reasonably tight to start with and may not be adequately reflecting both the tightening liquidity conditions as well as deteriorating macro-economic outlook.

In summary then the investment logic remains strong for overweight quality fixed income (3 to 6 year maturities as per our view). While investors may be balancing this with recent tax changes, there is need to be mindful of how much expansion of risk appetite is being undertaken especially in light of the evolving macro- economic and liquidity situation.

One also has to be reminded that tax on debt mutual funds is at worst at parity with most other fixed income options and not inferior to them. The other elements of liquidity, diversification, etc., very much remain with the mutual fund. Also, if we are right on our economic growth view, it is likely that credit growth slows over the year ahead and the yield curve steepens. This will also allow the value in moderate duration (3 - 5 years maturing) high quality debt mutual fund products to get revealed again versus very front end options that are currently absorbing a lot of investor monies.