Withdrawal Symptoms: May 2022

The Reserve Bank today made a surprise announcement on monetary policy. The Monetary Policy Committee of the RBI met on an off-cycle basis and decided to hike the repo rate by 40 basis points to 4.40%. The RBI also decided to hike the CRR by 50 bps to 4.5%.

This is a remarkable turn of events from the RBI. When the MPC announced the last policy on April 8^th, it indicated that there would be a withdrawal of accommodation. But an intra-meeting hike does suggest that the MPC members were perhaps more hawkish than that statement and the following minutes suggested.

As we thought, the April MPC was the first “post-pandemic policy” suggesting the unwinding of various policy measures the RBI took, chiefly:

• Repo rate cut from 5.15% to 4.00%


• Policy corridor widened from 25 to 65 bps, taking the reverse repo rate down to 3.35%


• Significant liquidity infusion through various open market operations

Between the April MPC and today’s announcements we are now well on the way to reversing all these policy measures. The rate hikes have started, the policy corridor has been restored to 25 bps and liquidity is being withdrawn.

The RBI Governor in his statement pointed to a certain symmetry in today’s hike. Two years ago in May 2020, the RBI had cut 40 bps in another inter-meeting rate action. That was the second and last policy rate cut of the pandemic.

That also raises the possibility of reversing the only other rate action during the pandemic: a rate cut of 75 bps in March 2020.

Subsequent monetary policy actions have occurred outside the MPC: widening of the policy corridor, infusion of liquidity through targeted repurchase operations, and infusion of liquidity through open market purchases of government securities (through OMO and GSAPs). Rather than taking the OMO sale route towards liquidity normalization, the RBI has opted to increase the CRR by 50 bps. This will absorb about Rs. 87,000 crores – more than 10% of the current excess liquidity in one shot.

The pace of action that is being suggested today seems in line with the expectations of the Deputy Governor Dr.Patra, who writing in the minutes said, “during the course of 2022-23 and up to April 2023, all pandemic-related extraordinary measures will cease.”

Supporting the MPC and RBI decisions today are the macro-economic data that have been released over the past several months. Inflation is running well above the RBI’s corridor and growth indicators appear to be pointing to a sustained recovery. If anything, these macro-economic parameters have been suggesting the same since the middle of last year, and the RBI appears to be catching up to reality.

Outlook

The out of turn rate and liquidity action suggests that the pace of policy normalization is likely to be faster than the markets had expected. It would seem that the RBI would want to normalize liquidity within the next 12 months, and possibly raise the repo rate above expected inflation. With inflation projected to average about 5.1% in Jan-Mar 2023, it would seem that the RBI is signaling repo rates to go back to the pre-pandemic level of 5.15% at the very least. That suggests further rate increases of 75 bps or more in the near term.

The immediate market reaction is therefore quite large. Intra-day, the 10-year benchmark gilt touched 7.4%, a rise of about 25 bps from this morning. Shorter term bond yields have risen by 40 to 50 bps.

The rise in short bond yields is a function of both rate action and liquidity. We must remember that the yield curve is extra-ordinarily steep and should flatten as monetary policy is normalized. This is typical of previous rate hike cycles as well.

From here on the market will await further action towards normalization of policy: that is, further rate hikes and liquidity withdrawal. As such we believe caution in duration stance. Additionally, a “bar-bell” strategy of holding a higher proportion of cash (money market instruments, floating rate bonds and the like) with a relatively small proportion in long bonds (typically beyond 5 years) is our preferred portfolio stance. This strategy is expected to outperform in flattening curve environments.

Allocation and strategy is based on the current market conditions and is subject to changes depending on the fund manager’s view of the markets. Data as on 30^th April 2022

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Disclaimer

Source of Data: RBI Governor’ Statement and Monetary policy committee statement on 4th May 2022, Axis MF Research

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