The calendar year has begun with a more decisive shift in the likely policy rate trajectory by most global central banks. The narrative of “transitory inflation” has been largely junked by most of the central banks, with policy focus shifting from the emergency settings induced by the pandemic towards the core goals of moderate inflation and macroeconomic stability. This has led to market expectations converging towards policy rate hikes by leading central banks along with unwinding of the quantitative easing (QE) programmes. The impact of the same has been felt in the domestic bond markets even as the Reserve Bank of India (RBI) policy guidance remains firm on enabling growth. At the same time, over the last quarter, the RBI has stopped adding primary liquidity and conducted frequent short tenor reverse repo auctions to signal higher short-term rates.
With a more restrictive global monetary policy setting as the base case, the outlook on Indian yields would be a function of how the RBI addresses the challenging task of managing liquidity, controlling yields, moderating inflation, and supporting growth. Given the contrasting objectives and with limited tools at its disposal, it is certain that this would entail significant volatility and maybe potential sub-optimal outcomes. In this context, one would expect that the primary action may continue to be liquidity modulation with an eventual target of aligning overnight rates closer to the policy repo rate. This would entail active absorption of durable liquidity that would have impact on yields.
In this context, it is interesting that RBI has recently resorted to open market operation (OMO) sales on the Negotiated Dealing System open market (NDS OM) in small quantities since the last week of November. Perhaps the provision of the market stabilisation scheme, if enabled in the FY23 budget, could be a better market friendly tool to absorb liquidity than the OMO sales.
Policy repo rates are likely to stay at 4 per cent in the near term, given the recent policy guidance by the RBI. However, as economic growth recovers, with the existing backdrop of high wholesale price index (WPI) and a sticky consumer price index (CPI) closer to the upper end of the target, the RBI would eventually need to revisit the existing policy rate settings. This is more likely to be a factor that could engage markets in the second quarter and beyond. Positive data on government finances as well as likely measures to enable bond index inclusion could be positive triggers at the margin.
The dominant theme over the year is likely to be the process of liquidity and monetary policy normalisation. A repricing of market levels as well as bond spreads is inevitable as this process plays out. This is more likely as the emergency policy and ultra-loose liquidity settings have sustained far beyond the initial timeline when such measures were necessitated on account of the lockdown.
What You Should Do
From an investor perspective, this process as it plays out would call for predominantly staying with a lower duration consistent with individual risk and liquidity requirements as well as asset allocations. A gradual resetting of shorter-end rates as anticipated should correct the significant steepness in the curve, thereby improving carry while being exposed to lower duration risk. The phase of repricing in market rates should provide reasonable entry points for closed-ended products and target maturity roll-down strategies with a holding period matching the scheme duration. Investment in floating rate products should ideally be aligned with a holding period that corresponds to the period of rate normalisation.
The author is CIO - Fixed Income, SBI Mutual Fund