Why gilt market should read between the lines


Cogencis, Thursday, Jun 6

By Bhaskar Dutta and Pratigya Vajpayee

NEW DELHI - On the face of it, the Reserve Bank of India's monetary policy statement today seemed to have everything the government bond market could have asked for.

Not only did the central bank lower interest rates by 25 basis points, but also relaxed its policy stance to 'accommodative' from 'neutral'. 

The bond market has perceived the change in stance as a sign that the RBI now believes that more room has opened up for easing monetary policy. But if one reads between the lines, the underlying message could be just the opposite.

Going by the RBI's definition, an accommodative stance implies that rates can only remain steady or head lower. On the other hand, the neutral stance that it held earlier had allowed rates to move in either direction. 

The obvious takeaway for the market was that the central bank sees the possibility of lowering rates at least two more times. After all, why would it go through the trouble of changing its stance if it plans to cut rates just once, or not at all from here?

But then, one has to keep in mind that the RBI was also faced with the arduous task of managing expectations in the fixed income market, a crucial link in the chain of monetary policy transmission. At a time when corporate cost of borrowing is already elevated because of the ongoing crisis in the non-banking financial sector, the central bank could not afford to let the bond market lose hope of further rate cuts.

Usually, the central bank communicates its intent to further cut interest rates by substantially lowering its inflation forecasts, and indicating that the risks to its projections are tilted to the downside. But the RBI's latest projections did not offer much scope to do so. 

The RBI raised its estimate for consumer price index-based headline inflation rate for Apr-Sep by 10 bps to 3.0-3.1%, while lowering its forecast for Oct-Mar by the same quantum to 3.4-3.7%. According to the central bank, the risks to these projections are broadly balanced.

Going just by these revisions, it is difficult to visualise any incremental space for easing the monetary policy, at least not to a significant extent. The only other way the RBI could have assured debt markets was by softening its policy stance. 

The importance of effective messaging from the central bank is evident from the government bond market's reaction to the previous policy statement in April, when yields rose 8 bps despite a 25 bps reduction in policy rates. Now that conditions in fixed income markets are even more precarious, the central bank would have wished to spare the disappointment it had caused last time by not easing its stance. 

The market reaction to the policy statement today was in stark contrast with that to the previous one. Yield on the 10-year benchmark government bond fell 9 bps to end the day at 6.93%, its lowest level since Nov 21, 2017. For bond traders, the biggest differentiator between the two policy statements was the RBI's stance. 

With the RBI's inflation projections not moving further south of its medium-term target of 4%, it might not be able to maintain its current streak of delivering back-to-back rate cuts in three straight policy meetings. So, even if the central bank is not in a position to lower the repo rate when it next reviews its policy in August, the bond market can hold on to hope. 

The RBI's accommodative stance does not necessarily mean that interest rates will steadily move downward, it merely implies that rates will not climb. Not that monetary policy tightening was seen as a risk in the current situation.

The change in stance notwithstanding, some market participants expect the central bank to lower interest rates just one more time, while several of them see the next cut arriving only in October.

Of course, there is no denying the scope for easing the monetary policy further, given that the inflation trajectory remains benign, and economic growth is faltering. The prospect of further reductions in interest rates may, in turn, maintain a downward pull on bond yields, dealers said.

Yield on the 10-year benchmark 7.26%, 2029 bond is seen headed towards 6.75% in the near term, nearly 20 bps lower than today's close. 

But it increasingly looks like the bond market might not have a rate cut to look forward to each time the RBI's Monetary Policy Committee meets every alternate month. In such a situation, betting on interest rate reductions might no longer be an easy call for bond traders, who would now have to take more risks into account. Say, if the next cut in rates is seen four months away, there is a lot that can change in the interim, especially on the global front, to jeopardise bond portfolios.

Considering the scale of expectations with which the bond traders headed into the RBI's policy statement today, the central bank would have been hard-pressed to please the market. The overnight indexed swap curve had priced in a 50 bps reduction in the repo rate, which might have been hard to grant. But the 10 bps fall in swap rates today suggests that the RBI has managed to humour the market, at least for now.  End 

Edited by Arshad Hussain

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