RBI Policy Expectation With Bond Market Assessment

Over the last few days the Union Budget 2020 has been analysed quite thoroughly. The bond market participants had eagerly awaited fiscal deficit numbers, government borrowing programme and the opening of the domestic financial market to foreign participation. The fiscal deficit for FY20 is revised to 3.8 per cent of GDP from earlier 3.3 per cent  by invoking the “trigger mechanism” to allow 0.5 per cent GDP of fiscal deficit slippage as per the FRBM Act. This was in line with market expectation given that the rate of revenue collection had been behind target for a while. Markets are largely comfortable with the increase in headline bond supply as the magnitude is not particularly large. However, Rs 2.1 trillion asset sale target will be difficult. The budget carries greater potential to influence bond prices via foreign flows into the bond market. This the most important development from the bond market perspective. Certain specified categories of government securities will be opened fully for non-resident investors, apart from being available to domestic investors as well. This is more material in terms of the likelihood of India’s inclusion into global bond indices, which could have a sizeable and durable flow impact.

Getting the policy mix right

Last year, the inflation remained under the 4 per cent target of RBI and growth deacceleration happened. The RBI reduced the interest rates by 135 bps. However, these rate cuts were mostly factored. Despite forceful monetary easing and a banking system awash with liquidity, the sovereign yield curve progressively steepened last year.  The government showed a fairly realistic and credible consolidation path for fiscal deficit in the coming years. This saw the yields inching down post the budget. 

Headline CPI has averaged less than 4 per cent  over the last three years, largely due to a sustained disinflation in food prices, which constitutes 46 per cent  of the CPI basket. That has changed, as over the last few months, food prices have begun to rise. Against this backdrop, the Monetary Policy Committee (MPC) voted unanimously to keep policy rates on hold in December 2019. Headline CPI accelerated sharply to 7.35 per cent  in December 2019, the highest level in more than five years. As the long bond yields kept moving up the RBI decided to commence “Operation Twist”—simultaneously selling short-end bonds and buying long-end bonds to compress term premia. 

In the upcoming RBI policy meet on February 6, 2020, the market expectation is that RBI will keep the rates and stance unchanged. The budget also indicated that the RBI will be continuing with operation twist in the next fiscal. The RBI has done everything in its capacity over the last one year to support growth by reducing repo rates, providing significant liquidity, linking bank rates to external benchmark and mitigating rupee appreciation. Despite this, the transmission of rates is low. However, as food inflation reduces in the coming months due to the incoming crop, it may provide the RBI with some head room for rate cuts later during the year.