Bullish Under The Hood : December Policy Takeaways

The MPC kept repo rate and stance unchanged as was widely expected, although one member voted for stance to be
changed back to neutral. The RBI cut SLR to 18% at the rate of 0.25% per quarter starting January. Key highlights as follows:

On CPI

The market got the cut to CPI forecast that it was looking for. In fact, the cut was quite meaningful to 2.7 – 3.2% in H2 FY
19 (from 3.9 – 4.5% in last policy) and to 3.8 – 4.2% in H1 FY20 (4.8% for Q1 FY20 in last policy). Given these numbers one
would have expected a much more dovish assessment. However, there seems to be a distinct sense of unease with respect
to the durability of the fall in CPI. Thus the MPC noted that the CPI outlook is driven mainly by an unexpected softening of
food inflation and collapse in oil prices in a relatively short period of time. Excluding food items, inflation has remained
sticky and elevated, and the output gap remains virtually closed. In the post policy call, Governor Patel also referred to
the large uncertainties in forecast and that a few more months are needed to see impact of MSP. He flagged risks of
sudden reversal especially in perishables. He also noted that volatility indicators in oil have not subsided even though
prices have fallen (which means that outlook on oil remains unstable). Finally, he also flagged risks to fiscal slippage as
influencing inflation outlook. However, it is here also that Dr. Patel also threw in the first dovish surprise: he said something
to the effect that if CPI upside doesn’t materialize, then there is possibility of space opening up for commensurate action.
This has given market first hopes in a direction no one was even daring to think about: the possibility of actual monetary
easing.

On Growth

There seems to be a clear assessment that global growth is slowing. However, what is somewhat surprising is that RBI still
assess the local growth outlook as quite robust. So the GDP forecast is retained at 7.4%, but with risks to downside. Thus
global slowdown, financial market volatility, and lower Rabi sowing is considered as risks. But on the other hand, the fall
in oil is seen as a strong positive to demand. To be fair, many of the indicators that RBI monitors are still robust. This may
be driving the sanguine view on growth and, by implication, output gap. Thus the higher import growth, stable business
sentiment in Q3, the strong composite PMI prints released recently, and non-food credit growing at 15% (higher than
GDP) were all mentioned as supporting the growth outlook.

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On Liquidity

Dr. Acharya explained that RBI was guided by principle of managing system-wide liquidity. It is also the lender of last resort
wherever needed, but he didn’t think that was required currently. He defended measures undertaken to alleviate recent
HFC / NBFC stress. There was a clear preference highlighted for OMOs and term repos for liquidity infusion. Dr. Acharya
mentioned that long term repos will be done around advance taxes. The second dovish surprise came from him when he
assessed that increased frequency of OMOs may be required till end of March. Additionally, the Governor was quite
emphatic in denying any need for a CRR change.

Takeaways

On the face of it, barring the drastic CPI cuts, the policy was quite neutral. The confidence in growth seems a shade too
robust, and we think there may be some downgrades here down the line. In particular, the lagged effect of recent
tightening of credit to certain sectors may have been somewhat underplayed. Having said this, the market got everything
it wanted. Thus it got confirmation that it was right in unwinding practically all future rate hike expectations. While it is
too soon to already start thinking of easing, the statement made by Governor Patel may at least start the discussion at
some point. This is especially true if CPI sticks to the forecasted path for the next few months and the current nascent
concerns about global growth were to get more amplified going forward. Indeed, the global context is quite relevant here
and has been one of our core pillars of fixed income view lately. In this respect, the recent mild inversion between 2 and
5 year US treasuries is inviting a lot of interest as potentially signaling market’s first tentative steps towards pricing in a
slowdown ahead, and the Fed potentially making a policy mistake by continuing to hike. These are nascent trends and can
easily reverse. But they definitely merit attention, coming as they do on the back of growth slowing materially in large
pockets of the rest of the world and in fact the US itself showing some sector specific weaknesses lately.

The other important clarification provided is that OMOs are likely to continue at a similar pace in the next quarter. There
was a chance that the pace would have come off in the next quarter. This was basis an expectation that the RBI will not
fully plug the core liquidity deficit by end March but may be comfortable with a INR 50,000 – 75,000 crore deficit. However,
it looks like that the central bank is likely to be more proactive and may attempt actual neutral core liquidity by March.
This could be emanating from a consciousness that there are sector specific liquidity challenges and hence RBI needs to
be even more proactive in abundantly delivering on its principle of managing system wise liquidity. This means the
favorable demand supply balance for government bonds is likely to continue till fiscal end.

From a strategy perspective, we reiterate here our view that the rate hike cycle is over and that one has to be long on
quality fixed income (sovereign / AAA). In our bond and gilt funds we have increased exposure to the 10 year point over
the past month or so through a combination of government bonds, SDL, and AAA bonds. At the very least, however, one
can no longer be underweight on AAA front end up to 5 years.

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05-Dec-18