A 6% terminal repo rate and bond yields in the 7.5-7.75% range look likely in this cycle
By Prasanna Balachander
Indian markets heaved a sigh of relief after the Monetary Policy Committee (MPC) chose to increase the repo rate by 50bps and left the CRR unchanged, thus meeting the median market expectations. Bond yields fell as an initial relief rally in response to the “no shock” policy. What, then, is the path ahead for growth, inflation, and markets in this financial year?
Domestic growth outlook remains good in the form of improving capacity utilisation, better core sector demand and normalisation in contact-intensive sectors affected by the pandemic, but the global growth outlook is far more dim. So, even as India is likely to be the fastest-growing large economy in the world, headwinds have started to appear. The World Bank just cut the global growth forecast for 2022 to 2.9% from 4.1% earlier. Global growth will remain at these levels in the next two years as well.
The rising differential between Indian and global growth implies lower export momentum and higher trade deficit. Higher oil prices will add to trade deficits as well. This has already become visible in the last two months of this financial year. Add to this the FPI outflows from India, and these factors could put further pressure on the Indian currency.
While global growth expectations are being consistently revised downwards, inflation remains stubborn. The recent rally in the global markets was driven by the anticipation of US inflation having peaked, and of it gradually coming down. However, the big debate is whether the US CPI will settle closer to 2% or above 3% by end of 2023. Expectations around this will influence how the US Fed will move in the coming months. While consumer confidence in the US is coming off and retailers are pointing to an incoming slowdown, whether it will be enough to bring inflation down when the labour markets are extremely tight is the big question.
As of now, markets are pricing-in the US Fed raising rates closer to 3% in early 2023. This expectation has not changed from the last off-cycle hike undertaken by RBI. However, what has changed is the market’s view on ECB, which is now expected to raise rates aggressively to counter an inflation problem. Supply-side issues and the war are impacting Europe more than the US. However, in both regions, the labour markets are tight. Thus, if the US and ECB will have to raise rates higher than what we see currently, the Indian risk-free rate will also have to be higher.
That brings us to the domestic inflation outlook. RBI raised its inflation forecast for FY23 to 6.7% from 5.7%. With this, it seems to be slightly ahead of the median estimates. Its current estimate is based on crude oil prices at $105/barrel when crude is trading closer to $120/barrel. While higher interest rates will play out with a lag and drive inflation lower, there are upside risks clearly visible in other areas.
For now, the terminal repo rate is likely to be 6%. With this, real repo rate will be positive in Q4FY23 when RBI estimates inflation to be at 5.8%. This seems to have allowed a sigh of relief to the bond markets, which rallied after the policy, but have retraced from the lows. However, there is an impending demand-supply imbalance. RBI has been a major buyer of government securities since the pandemic struck. This year, RBI is actually selling government securities, though in quite moderate amounts. States are also expected to borrow much more given that GST compensation will end after this quarter.
In addition to this, the government has stepped up its spending on food and fertiliser subsidies to counter the impact of higher international prices. Even excise duty on petrol and diesel has been reduced along with reduction in custom duties on certain imports. These will reduce inflation, but also have a revenue impact. At the same time, revenue buoyancy visible in direct taxes and GST will make up for some of the higher spending. Even so, there is a fiscal gap that is opening up which implies higher yields. The RBI Governor did cover managing the borrowing programme in his statement and post conference interaction by way of Operation Twist in which the central bank may buy long-end bonds while selling short-end ones. On the basis on domestic fundamentals, yields are likely to be in 7.5-7.75% range.
Global factors, for now, are also favouring higher yields. The US 10-year, which had recently corrected to 2.74% from a high of 3.12%, has again moved up to an above-3% level. German yields have moved from negative levels from as early as March to more-than-1.3% levels now.
Last but not the least, the extent of liquidity in the banking system will also be an important determinant of interest rates. The MPC/RBI continues to guide the market towards achieving “normal liquidity conditions” going forward, which implies systemic liquidity of ~1.5% of NDTL (~`2.5 trillion) and Weighted Average Call Rate (WACR) tracking the repo rate rather than the SDF rate. Towards this objective, RBI has already hiked the CRR by 50 bps and has refrained from any Open Market Operations purchases. Going forward, it is expected that the liquidity surplus could further reduce, given organic currency demand and CRR increase, and the need to fund a widening BOP deficit. This would ensure that overnight rates start tracking the repo rate rather than the SDF rate, say, by the end of the year, implying another 25bps of effective tightening.
On balance, while a 6% terminal rate for the repo in this cycle seems likely as of now, the current backdrop suggesting higher oil prices, higher inflation trajectory and a more aggressive US Fed could imply a terminal repo rate higher than 6%, but that is a thought for another day!
(The writer is group head, Global Markets, Sales Trading & Research, ICICI Bank; Views are personal)