RBI policy over, global factors to dictate market trajectory from here on

Squeezing of liquidity and the likely hardening of bond yields may have a near-term "sentiment" effect on the BFSI sector; overall the policy should not have too much bearing on the equity markets

The RBI MPC voted unanimously to keep rates unchanged and voted 5-1 in favor of continuing with its ongoing  accommodative policy stance. Although there were some expectations in the markets that RBI would raise the reverse repo rate, the MPC continued with its ongoing accommodative stance and left policy rates unchanged. 

While the RBI does acknowledge that the domestic economic activity is gaining momentum with the second Covid wave effects receding in the country, it probably wants to be watchful of the slack in the economy, the recovery being uneven, growth still being below pre-pandemic levels, and some of the global economies showing signs of slowing down. 

On the inflation front, the MPC looks to be a bit more confident this time, and expects the headline CPI inflation to moderate in the coming months with food prices softening, although core inflation is still ruling on the higher side and oil/commodity prices are hitting new highs. Expectedly, the MPC has revised downwards its CPI projections for the coming quarters.

The noticeable progressive shift, however, in the MPC’s posture, is the more aggressive tapering of liquidity. While in the previous policy the RBI had announced a hike in the quantum of the fortnightly VRRR auctions from Rs 2 trillion to Rs 4 trillion, the current elevated surplus liquidity conditions through September and early October have prompted the RBI to raise the quantum further to Rs 6 trillion / fortnight, by 3 December. This should effectively bring down the surplus liquidity to about Rs 2 – 3 trillion by December. This is quite likely a precursor to an imminent hike in the reverse repo rate (likely in December), and to reduce the MPC policy corridor that had widened last year during the pandemic. Further, RBI has also opened up the possibility of conducting 28-day VRRR auctions, if the situation warrants, for a more lasting impact of the liquidity withdrawal.

The taper signal from the RBI is also evident from the discontinuation of the G-SAP programme that it had started earlier in the year in order to anchor the long-term yield expectations. So while RBI intends to continue with OMOs and Operation Twist as and when required, the extra liquidity inducement at the longer end of the yield curve will now cease.

Likely Implications

Bond markets: The measures announced in the policy are pretty much as we expected - that liquidity tapering would be accelerated and result in an eventual hike in the reverse repo rate, possibly by end of the year.

Short-term interest rates have already bottomed out some time back, and should drift somewhat northwards with the enhanced withdrawal of liquidity by the RBI. The steepness in the yield curve can thus reduce gradually through next year, with the hardening of short-term rates. In the absence of G-SAP support going forward, long-term (g-sec) rates will likely move in tandem with the RBI activity on the OMO and Operation Twist front, to balance out upward pressure on yields from the ongoing auction supply from the Government borrowing. Overall, the yield curve should gradually shift upwards, although the RBI is mindful that it should prevent any disruption in the bond markets or in the liquidity situation.

Equity markets: In general, the policy should not have any direct impact on the equity market outlook. As laid out by the Governor in his policy address, domestic growth seems to be picking up comfortably, and there has been reasonable progress on the vaccination front, too.

From Indian equity markets perspective, global factors will be more relevant at the current juncture: the “positive” backdrop of the global economic recovery and stable global equity markets so far, as well as certain “headwinds” on the other hand – the rising US bond yields, high global commodity, oil and energy prices (fueling global inflationary trends), the Dollar index standing firm (which is generally not encouraging for flows into Emerging Markets) and the ongoing regulatory and property-related developments in China that could potentially affect sentiment for the EM basket in general.
 

Although RBI is quite confident about food prices remaining moderate going forward, we need to be watchful about “imported inflation” – higher energy and commodity prices, and the resultant pass-through to the economy in terms of inflationary trends and pressure on corporate margins.

To some extent, the squeezing of liquidity and the likely hardening of bond yields may have a near-term “sentiment” effect on the BFSI sector, but overall the policy should not have too much bearing on equity markets. The broader outlook is more a function of the evolution of demand and momentum in the domestic economic activity, and not so much the interest rates, at the current juncture. There has been a seasonal demand improvement of late in the auto and discretionary consumption sectors. Over the longer term, we are positive on financials, consumption, healthcare and IT (after the recent correction in some of the IT stocks).

Unmesh Kulkarni is Managing Director and Senior Advisor, Julius Baer India. Views expressed here are his own.