Switch to debt if equities look expensive

Nifty is trading at a PE of 19, implying that risk-free rates are in the 5-6% zone. Debt yields are well above that

The Reserve Bank of India (RBI) left policy rates and cash reserve ratio (CRR) unchanged in its first policy review of 2014-15. It put a ceiling on gross domestic product (GDP) growth expectations estimating the Indian economy wasn't capable of exceeding six per cent and revealed a survey suggested consensus expectations of GDP growth were at 5.5 per cent. The RBI also expressed hopes the 16th Lok Sabha would have a stable government, with accelerated reforms and improved fiscal discipline.

Assuming inflation continues to ease, the RBI will not tighten again in this fiscal. The treasury bill auction on April 2 will give us an inkling of how the bond market sees this policy stance. The stock market seems to have shrugged it off with a mild correction in financials.

The first inflation target is the Consumer Price Index at eight per cent or lower (year-on-year rate of change) by January 2015, with a second target of six per cent by January 2016. The February 2014 CPI was at 8.1 per cent. Arguably, the RBI is close to meeting its initial target well ahead of schedule.

However, inflation could spike through FY2014-15 for several reasons. First, the monsoon may be below par if the current predictions of El Nino hold true. In that case, food prices will climb steeply again. A second inflationary possibility is the campaign process itself will pump enough funny money into the economy to make inflation climb. A third possibility is the Crimean crisis will lead to a stand-off with Russia, which will trigger a rise in global oil and gas prices. And, of course, fiscal mismanagement and refusal to reform are both very likely outcomes regardless of which political formation comes to power.

Put it together and the RBI is likely to continue being very cautious till there's a new government installed and the monsoons are well underway. It also has to brace for the  tapering of US’s QE3, which looks likely to accelerate. Tapering coupled to expectations of a rise in US rates in the first half of 2015 could lead to a stronger dollar and weaken the rupee.

The RBI will also have a demarcated trading band for dollar-rupee. It will buy dollars when the rupee strengthens to the top of that band, weakening the rupee and fattening reserves. If the rupee hits the bottom, the RBI will sell dollars, or offer swaps once again to petroleum public sector undertakings, etc, to pull the rupee back up.

My guess is the RBI won't touch rates or CRR in the next policy update in June if the economy remains more or less on the current track. The boffins in the RBI will want to absorb the implications of the new political dispensation, and the new Budget and update guesses about the economy and the national balance sheet before it commits to changes in monetary policy.

This means we can expect a consistent monetary policy through April to early August, unless there's a serious swing in inflation, or serious exchange rate volatility. The RBI generally ignores swings in the stock market unless it affects the exchange rate. A major foreign institutional investor (FII) pull-out could provoke some action by the RBI but even then it's not likely to raise interest rates.

The repo rate (at eight per cent), coupled to treasury bill yields and bank/corporate fixed deposits, gives the investor a fair idea of relatively low risk or risk-free returns. Compare that to the market valuations of stocks — an inversion of PE ratio (earnings divided by price) is a rough guide. The stock market seems somewhat overvalued since the Nifty is trading at a PE of 19, implying that risk-free rates should be in the zone of five-six per cent. Debt yields are well above that.

The author is a technical and equity analyst