The recent hardening in Gsec yields is likely to continue with possibility of Fed lift off
RBI maintained its key policy rates in line with our as well as consensus expectations. Overall, we believe that RBI will keep policy rates unchanged until the Union budget in Feb'16th wherein the RBI will watch on how the government manages the impact of 7th pay commission stays on its committed path of fiscal prudence.
The recent hardening in Gsec yields is likely to continue with possibility of Fed lift off, inducing volatility in liquidity flows. The 10 year Gsec yield is expected to harden to 8%. INR/USD has been weakening in line with our long held thesis; we maintain our target of 68-70.
While RBI has maintained its real GDP growth target at 7.4%, the bias is on the downside. This appears to be prompted by growth slowdown in China and Euro area and also indicated by domestic factors such as poor monsoon, weak rural demand, slowing construction activities, sustained weakness in private investments and slower transmission of policy rate cuts by the banks.
On the positive side, growth is seen to be supported by higher government spending, which along with lower commodity prices can provide enabling environment for pickup in private investment demand.
There also some signs on revival in urban demand particularly export oriented items such as readymade garments, pharmaceuticals and electronics which are experiencing initial turnaround. The RBI expects recent initiatives by the government in areas such as roads, railways and ports to improve construction activities.
RBI has also indicated that inflationary risks are slightly benign and have maintained the target of 6% by Jan'16. However, RBI has highlighted that the risks emanating from weak rabi crop sowing, continuous rise in prices of services which are non-tradable, house rental prices and seventh pay commission if government does not resort to appropriate budgetary tightening, need to play out favourably to achieve the expectation of 6 per cent.
There are several constraining factors for rate actions that RBI has highlighted. These include, rising possibility of US Fed liftoff in Dec'15 on the back of strengthening growth which are inducing hardening bias for treasury yields in EMs along with currency weakening due to stronger USD.
Increasing sensitivity of India Gsec yields to hardening US treasury yields and INR depreciation have resulted in steepening of India yields curve in the long end with 10-year rising to 7.80% following a temporary decline to 7.5% when RBI announced its earlier 50bp cut in policy rate in September 2015.
In a context of rising US yields and higher Fed rate, attempts by RBI to cut rates significantly from here will be out of sync and will be froth with risk of steeper currency depreciation.
From the domestic standpoint, the transmission of policy rate reduction of 125bp since Jan'15 has had a limited impact on lending rates of banks, which has declined by just 60bp, which also challenges the efficacy of policy actions of RBI.