With the weak GDP growth in the Jun-17 quarter, the debate on providing stimulus to the economy reemerged. However, the prospects of a rate cut had been dampened by the August CPI inflation print of 3.4%, which surprised on the upside.
Indeed, with inflation expected to rise closer toward the RBI's inflation target, we do not think there is much room to ease monetary policy further. Moreover, the potential fiscal easing would have to be evaluated in the context of its impact on inflation.
As private capex remains relatively subdued, it has been suggested that further easing (in the form of lower rates) will help boost growth. However, in this regard, the RBI has taken the view that actions to resolve the banking system's non-performing loans will be key to fostering the recovery in capex and credit demand areas as opposed to further rate cuts. This was most recently emphasized by the governor in the last MPC minutes, where he noted that "Resolution of stressed balance sheets of banks, therefore, will remain important for reviving credit demand and the investment cycle."
Taken together, we think this translates into an MPC vote of 5-1 to keep rates on hold while maintaining a neutral stance (Dr. Dholakia will likely continue to press the case for further easing).
INR rates and FX have underperformed on media reports of potential fiscal stimulus. While we await more details on fiscal policy, assuming that increases in fiscal spending would likely be small and targeted, we think India's macro fundamentals of high real rates, increased financial savings and structurally lower inflation will remain supportive of rates.
IGB valuations are not rich relative to these fundamentals, while 5y NDOIS looks cheap relative to monetary policy expectations. We look to add long IGB 5y on upticks toward 6.75%, preferring to stay in lower-duration bonds, given the evolving fiscal outlook. Should the MPC show concern on the slowing growth and negative output gap, we would look to receive 5y NDOIS.
On INR FX, we think fundamentals of a positive BoP remain supportive for INR, while INR REER over-valuation has moderated following moves over the past week. Technical momentum for USDINR upside should start to look stretched toward 67.0 levels.
The above note has been excerpted from a Morgan Stanley report.