RBI is widely expected to cut rates by 25bps in its policy review meet on the 1st and 2nd of August 2017. We expect RBI to cut rates by 50bps given weak economic data, strong INR and surging capital flows. CPI inflation printed at 1.54% for June 2017, below RBI’s range of 2% to 3.5% for the 1st half of this fiscal year. Core CPI inflation is trending around 4% levels, which is at RBI’s inflation target of 4% +/- 2%. IIP growth for May 2017 was at 1.7%, below 3.7% growth seen in April and 8% growth seen in May 2016. June exports growth was at 4.39%, down from 8.78% seen in May and 19.79% seen in April.
Bank credit growth is at around 6% year on year as of June 2017 and the banking system is still reeling under bad loans. Despite weak economic data, foreign portfolio flows have touched USD 25 billion calendar year 2017 to date. Foreign exchange reserves are at record levels of USD 391 billion and the INR has appreciated by over 4% against the USD over the past few months.
Fed chair Janet Yellen stated that inflation expectations are uncertain post the FOMC meet last week. Markets expect a gradual pace of tightening and this has led to a weak USD, which is trading at multi year lows against majors and has lost 3.7% over the last one year. USD weakness is spurring emerging market currencies including the INR, leading to strong capital flows. RBI has been buying USD in spot and forward markets to prevent sharp appreciation of the INR and will cut rates to lower interest rate differentials to weaken flows and prevent excess liquidity in the system.
10 year gsec yields will trend down on rate cuts, whether its 25bps or 50bps. However, if RBI cuts by 25bps and guides for no further rate cuts, there will be profit taking in the market leading to yields rising. No rate cuts can lead to yields rising sharply by 25bps.
Government bond yields rose last week on nervous markets ahead of RBI policy. The new benchmark 10 year bond, the 6.79% 2027 bond saw yields close up by 3bps week on week at levels of 6.46%. The old 10 year benchmark bond, the 6.97% 2026 bond, saw yields close up by 3bps at 6.67% levels while the on the run bond, the 6.79% 2029 bond saw yields close up by 6bps to close at 6.76%. The long bond, the 7.06% 2046 bond saw yields close up by 4bps at levels of 7.08%. Gsec yields will fall on rate cuts.
OIS market saw one year OIS yield close up by 2bps and five year OIS yield close up by 5bps last week. One year OIS yield closed at 6.20% while five year OIS yield closed at 6.27%. OIS yields will move down on rate cuts.
Corporate bond yields except 10 year bond yields closed flat last week. 10 year benchmark AAA bond yields closed higher by 10bps at 7.33% levels with spreads up by 7bps at 77bps levels against the new 10 year benchmark gsec, the 6.79% 2027 gsec. 3 year AAA spreads were lower by 1bps at 50bps and 5 year spreads were lower by 4bps at 43bps. Benchmark 3 year AAA corporate bond yields closed flat at 7.03% levels. 5 year benchmark AAA bond yields closed flat at 7.08%. Credit spreads are likely to come off further on liquidity and rate cuts.
System liquidity as measured by bids for Repo, Reverse Repo, Term Repo and Term Reverse Repo in the LAF (Liquidity Adjustment Facility) auctions of the RBI and drawdown from Standing Facilities (MSF or Marginal Standing Facility and Export Credit Refinance) and MSS bond issuance was in surplus of Rs 4319 billion as of 28th July 2017. The surplus was Rs 4625 billion in the week previous to last. Liquidity will stay easy on government spending and RBI fx purchases.