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Go long on duration strategies in bonds, overweight on equities

RBI likely to leave benchmark rates unchanged in review but could cut rates going forward.

On a longer time-frame, RBI is expected to cut rates by up to 75 basis points. On a longer time-frame, RBI is expected to cut rates by up to 75 basis points.

For those struggling with high interest rates on their home loans and the ones planning to take on a car loan, the long wait for a softening of the interest rate regime is only expected to get longer. Analysts are almost unanimous in their view that the Reserve Bank of India (RBI) is likely to leave its benchmark interest rates unchanged in its upcoming review on August 5. An easing of its monetary stance is unlikely until early next year on fears of food inflation spiking in the wake of the deficient monsoons.

There could be three compelling reasons for this view:
Cumulative monsoon deficiency of 24 per cent has led to a buildup of food price pressure.
* The impact of hike in railway fares is yet to translate fully into inflation pressure.
* Through crude oil, India remains exposed to ongoing geopolitical unres.t

On a longer time-frame, though — i.e. between now and mid-2016 — the central bank is expected to cut rates by up to 75 basis points. While worries that the country could face its first drought in five years have receded marginally after rainfall increased in mid-July, the poor start to the monsoon has forced farmers to postpone summer sowing. The reviews subsequent to the upcoming one on August 5 is likely to have better clarity on this and expected to factor it in.

“Even though the headline WPI and CPI have eased over the last few months, and the intensity of monsoon rains has picked up after a weak start, rainfall-related concerns persist as a source of risk for the inflation outlook,” said Aditi Nayar, senior economist at ICRA. The RBI is targeting retail inflation of 6 per cent by January 2016. Inflation, measured by the CPI, eased to 7.31 per cent year-on-year in June. Analysts assert that with the target so stiff, the room for the central bank to cut rates is sharply reduced.

In its last policy review in June, the RBI had kept the repo rate — at which it lends to the banks — unchanged at 8 per cent. Exhibiting signs of revival, India’s manufacturing activity, gauged by the index of industrial production (IIP), had risen to 19-month high of 4.7 per cent in May on account of improved output from mining, power and capital goods sector. However in its June policy, the RBI offered some respite by cutting the statutory liquidity ratio (SLR) by 0.5 per cent to 23 per cent that allowed banks to have an additional Rs 40,000 crore and expanded their scope for more freedom to give credit to non-government sector.

On rates, clearly, the RBI is unlikely to yield this time round. The chairperson of the country’s largest lender, State Bank of India, Arundhati Bhattacharya last week had said that the RBI was likely to keep interest rate intact in its upcoming monetary policy review next month. This view was echoed by Soumya Kanti Ghosh, Chief Economic Adviser, Economic Research Department, SBI. In a research report, Ghosh maintained that in the run-up to the monetary policy on August 5, the overwhelming consensus is of the RBI maintaining status-quo in repo rate. “We would largely believe so. We are convinced that the retail inflation trajectory will be significantly benign till November 2014, beyond which it will show an uptick to be closer to 7.5 per cent by March 2015. Hence, the best time to go for a rate cut could be now, or may be around October 2014.”

He also said that frontloading a rate cut in anticipation of a rate hike in US could be a better policy option. “Meanwhile, we believe that the monsoon concerns have been literally overplayed by the markets and it may be best to ignore such as a selective amnesia. With the meteorological department predicting normal rainfalls in August, our projection based in past trends is a rainfall shortfall marginally over 10 per cent from long period average (LPA) in current fiscal. This will be good news for the markets. Interestingly, even as real deposit rates have turned positive, deposit growth have moved down significantly.

This indicates that for a developing country like India, the classical loanable fund theory may not hold correct. Interest rate might have some influence on saving but the influence of changes in national income may be a dominant factor determining the aggregate level of savings in any period. We also, believe that the RBI may rationalise the HTM requirement and the SLR requirement of the banks to a common ground, through an announcement of a time table. However, for that to happen, the daily CRR requirement may have to tweak so that the system does not have any frictions in liquidity. This apart, to streamline liquidity management, the RBI may (a) also look to conduct term repos on a more frequent basis and (b) look at ways to sterilise the excess reserves with banks by introducing a remunerative standing deposit facility,” Ghosh maintained in the report.

According to an analysis by Yes Bank, while RBI has been taking incremental steps for a supportive growth environment, credit off take has remained lacklustre due to elevated levels of bank lending rates and reliance on non-bank sources of funding.  In next week’s policy, it suggested that the enhancement of the term repo window and a relaxation in daily CRR maintenance to 90 per cent from 95 per cent are some of the measures that could be explored by the RBI to ease frictional money market stress.

In light of these projections, the prescription for investors would be:
* With global investor risk appetite clearly back and the Indian economy on a consolidation phase, it might still pay to go overweight on equities.

* In light of the consensus opinion that interest rates will start a downward trend later in 2014, it might pay to go long on duration strategies in bonds.

* If inflation continues to fall, it might make sense to start moving out from gold.

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