Interest rates view update!

Interest rates view update!

Last updated: 17 Sep, 2020 | 03:26 pm

Interest rates view update!

What’s happening in the current environment

  • Central Banks around the world are cutting interest rates to promote growth and liquidity. As predicted by INDmoney earlier, the Federal Reserve left interest rates near zero and signaled that it would hold rates there till at least 2023 to help the US economy recover from the coronavirus pandemic.
  • The FOMC expects to maintain an accommodative stance of monetary policy until it achieves inflation averaging 2% over time and longer-term inflation expectations remain well-anchored at 2%. Clearly, the focus is on providing impetus to growth in these turbulent times. 
  •  Back home, the RBI has cut repo rate by 115 bps from 5.15% to  4% since January 2020. This is the lowest rate since 2000.
  • While the RBI has cut rates in the recent past increasing the availability of money in the economy, the effects of these cuts haven’t been felt to a large extent.
  • Despite the moves by RBI, banks have not been extending credit to the cash strapped economy. This is because of the heightened risk aversion by banks in lending, currently caused by a widespread disruption in the economy.
  • Clearly the RBI has a problem of transmission. Rate cuts are having a limited impact in giving business and the economy a boost since banks are unwilling to assume the credit risk in this choppy environment.
  • The government has resorted to a much needed Fiscal stimulus by schemes that directly put money in the hands of certain targeted sectors- although much more is expected.
  • RBI is also implementing operation twists and open market operations to reduce the long term yields and speed up the effectiveness of transmission of rate cuts.
  • While there is pressure on the RBI to keep rates low (Dovish in monetary policy parlance), the RBI will remain constrained to cut rates meaningfully given the factors above and possible impact on currency (lower interest rates lead to outflows from the country)

What can be expected going forward?

  • In the previous bi-monthly monetary policy meet held in August, RBI had kept the repo rate unchanged at 4%. The reverse repo rate too remained unchanged at 3.35%.  
  • The MPC also decided to continue with the accommodative stance as long as it is necessary to revive growth and mitigate the impact of COVID-19 on the economy while ensuring that inflation remains within the target going forward. 
  • RBI said that these decisions are in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4% within a band of +/- 2%; while supporting growth.
  • However, at 6.7% in August, Consumer Price Inflation has remained well above RBI’s tolerance band of 6%. “In fact, CPI inflation has remained above the Monetary Policy Committee’s target for the fifth straight month in August, even though it reduced marginally compared to a month ago.”
  • The chart below shows India’s CPI Inflation in FY21.
  • With the CPI inflation for August 2020 sticky at a sharp 6.7%, a repo cut in the upcoming policy review on October 1st seems to be virtually ruled out.
  • This leads us to believe that we are at the bottom of the rate cut cycle. Even if the economic pick up is slow, we don’t see rates falling by over 50 bps over the next 6 months. 

What could happen in the long-term?

  • Monetary policy changes and fiscal measures are good measures to promote growth in the short term given the devastating impact of shutdowns in the economy. 
  • However, in the long term, fundamental factors of the economy guide real growth and sustainability.
  • As expected, the Government’s revenue decreased significantly during the lockdown but bounced back to 85-90% of pre-COVID levels in August-20.
  • The economy is saddled currently with high unemployment (even in pre COVID times) and low demand (Private consumption is at multi-year lows), businesses are struggling. 
  • With high government expenditure, low revenue and a depreciating currency, India’s fiscal deficit is continuously increasing (the difference between total income and total expenditure). 
  • “India’s fiscal deficit has breached the full-year target in April-July as the lockdown hit the government’s revenue and shot up the expenditure. The gap between revenue and expenditure reached Rs 8.21 lakh crore as compared to the budgeted ₹7.96 lakh crore for FY21.”
  • The government had set the fiscal deficit for FY21 at Rs 7.96 lakh crore, or 3.5% of GDP. 
  • As the lockdown eases, day to day business activities will resume. Demand will slowly start pushing back. This is still far away but we should see some impact in the coming quarters.
  • The fiscal deficit has a strong impact on inflation. As fiscal deficit increases, inflation picks up (to fund the deficit). 
  • Given the fragile state of India’s economy and currency, we can not afford to let the deficit run too far ahead.

The current state points to a bottoming of the current interest rate cycle and rates should increase in the long term (1-3 years) 

This is exactly what happened post-2008 global recession. During the crisis, RBI reduced interest from 9% to 4.75% in a span of 1 year. Then as inflation picked up, rates started increasing.

INDmoney Recommendation

The credit risk, interest risk and liquidity risk are extremely serious in the system. It is very important to understand them before making any decision. Invest only high-quality AAA-rated bonds as they have the least risk. In fixed income securities, high risk does not mean higher returns.

There is a significant tax advantage in holding a debt fund for more than 3 years. 

For a more than 3-year investment horizon, an investor should prefer short duration (duration < 3) fixed income instruments over long duration. Short duration funds might not give you that extra alpha in the short term(3-6 months) but they are highly likely to outperform long duration funds in the long term.