RBI Governor Rules Out Rate Cut: Govt Bond Yields Harden

The Reserve Bank of India (RBI) Governor Mr. Shaktikanta Das has ruled out the possibility of a rate cut in near future. “Rate cut at this stage will be very premature and can be very, very risky. When your inflation is 5.5 per cent and the next print is also expected to be high, you can’t be cutting your rate, more so if your growth is also doing well,” he said at Bloomberg’s India Credit Forum. He signaled that RBI would only consider rate cuts once inflation is durably aligned with the 4 per cent target. “I would not like to speculate on a rate cut in advance. We will need to wait for incoming data,” he emphasized. Considering the RBI Governor’s statement, a rate cut in the December monetary policy meeting now appears unlikely. The announcement has sent ripples through India’s bond market, with bond yields reacting swiftly. The yield on the benchmark 10-year government bond spiked as the market digested this firm stance from RBI.

RBI uses its key repo rate, the interest rate at which banks borrow from it, primarily to manage inflation, which spiked to a nine-month high in September. A lower rate can spur borrowing, consumption and economic activity. But RBI has kept its repo rate unchanged at 6.5% for nearly two years, and continues to do so, despite the US Federal Reserve and the central banks of some other countries lowering their policy rates recently. The Governor’s comments are the first public statement from RBI on inflation since the September data came in at a worse-than-expected 5.49%.

While RBI kept its policy rates unchanged in its October Monetary Policy Committee (MPC) meeting, its policy stance change to neutral indicated a preparedness to ease the rates. But the RBI Governor has repeatedly said that RBI wants to see inflation settling at around 4% on a durable basis before considering a rate cut.

Let us delve into the recent movement in government bond yields, reasons behind RBI’s cautious stance on rates, inflation’s influence on policy decisions, and the broader implications for the bond investors.

Benchmark 10-Year Government Bond Yield Movement:

In the immediate aftermath of the RBI Governor’s statement, the yield on the benchmark 10-year government bond moved higher, crossing levels that it had previously hovered around. This yield has been sensitive to policy signals, often reacting to both the domestic and global interest rate trends. RBI’s decision to maintain current rates signals a stronger push for yield hardening, making bonds more attractive to yield-seeking investors but also raising costs for potential borrowers.

Key Reasons behind RBI’s Refusal to Cut Interest Rates:

The RBI Governor’s stance stems from multiple concerns that continue to loom large over the Indian economy:

1. Persistent Inflationary Pressure: One of the foremost reasons for RBI’s reluctance to cut rates is India’s ongoing inflation concerns. In recent months, inflation data has shown a consistent upward trend, with retail inflation rising to concerning levels, primarily due to supply constraints and high demand in sectors like food and fuel. The central bank has been vocal about inflation remaining well above its target range.
2. Headline Inflation: India’s headline inflation, measured by the Consumer Price Index (CPI), climbed sharply over the financial year, reaching 5.49% in September. This is driven largely by persistent increases in food and energy costs. RBI’s medium-term target for CPI inflation is 4% within a band of plus or minus 2%.
3. Core Inflation: Core inflation, which excludes volatile items like food and fuel, has edged slightly higher to around 3.5 per cent in September, indicating that underlying inflation pressures persist. RBI is particularly wary of core inflation, as it represents sustained price pressures that can undermine economic stability if left unchecked.
4. Food Inflation: Food inflation has been particularly troubling, surging to 9.24% on average, with spikes in key items like vegetables, edible oils, and grains due to erratic monsoon patterns and global supply chain disruptions. This not only fuels headline inflation but also affects consumer sentiment and spending, pushing RBI to maintain a vigilant stance.
5. Global Crude Oil Price Impact: With high and volatile crude oil prices, India’s import costs have risen, adding fuel to inflationary pressures. Higher crude prices affect fuel, transportation, and production costs, which ripple across sectors, intensifying retail inflation. This oil price surge is a crucial element in RBI’s caution, as energy costs are deeply interwoven with food and consumer goods pricing.
6. Clarification on Exchange Rate: Addressing the concerns about Indian currency’s stability, the RBI Governor has emphasized that “RBI is not managing the exchange rate.” This position underscores a focus on domestic stability, rather than intervening in the foreign exchange market to stabilize the rupee, even as rising oil import costs put pressure on the Indian currency.
7. Global Rate Movements: Even though some central banks, such as the U.S. Federal Reserve, have either cut rates or hinted at cuts, the inflationary pressures domestically warrant a more conservative approach. A premature rate cut could disrupt forex stability, make Indian rupee volatile, and create capital outflow challenges.
8. Monetary Transmission Mechanism: RBI has also been cautious about maintaining an effective transmission mechanism within the banking sector. Rapid rate cuts could disrupt lending activities, potentially reducing credit availability to crucial sectors, especially during this inflation-sensitive phase.

Impact of the Statement on the Indian Bond Market

After the RBI Governor ruled out a rate cut, Indian bond yields have generally trended upward, reflecting investor sentiment that interest rates may remain elevated for a more extended period. Here’s a breakdown of the main reactions:

1. Rising Bond Yields

• The 10-year government bond yield, a key benchmark, experienced an increase as investors adjusted their expectations in line with the Governor’s statement. The yields on 10 year government bonds which stood at 6.732 on 1^st October 2024, rose to 6.841 on 31^st October 2024. Higher yields typically signify increased demand for returns on new bonds to compensate for the likelihood of stable or rising rates.
• Yields on shorter-maturity bonds also saw some upward pressure, as investors reconsidered their positions across various tenures.

2. Bond Prices Decline

• Bond prices have moved inversely to yields, with prices decreasing as yields rose. This reaction is typical when rate cuts are off the table because existing bonds with lower yields become less attractive.
• The decline in bond prices is most pronounced in longer-duration bonds, which are more sensitive to interest rate expectations.

3. Investor Sentiment and Market Liquidity

• Investor sentiment has been impacted by concerns over inflation and the possibility of prolonged high rates, leading to cautious activity in the bond market.
• Liquidity in the bond market has also seen fluctuations, with some outflows as investors reallocate to assets potentially offering better returns in a stable or rising rate environment.

4. Impact on the Overnight Index Swaps (OIS) Market

• OIS rates are a key indicator for understanding market expectations regarding future policy rates. The OIS market has reflected expectations for a stable or rising rate environment in recent weeks, with traders factoring in limited scope for a rate cut. Following the Governor’s announcement, OIS rates adjusted to higher levels, signaling that investors should be prepared for a somewhat prolonged phase of high rates in the bond market.
• OIS rates’ adjustments following RBI’s decisions offer insights into future rate projections, and the elevated levels can mean that the bond market anticipates minimal softening in policy rates in the near term.

5. Foreign Investors’ Responses

• Foreign investors, who often seek rate cuts for capital gains on bonds, may continue to adopt a cautious stance on Indian bonds. This can exert pressure on bond prices and lead to reduced inflows into the bond market.
• This shift has implications for bond investors, especially those invested in longer-duration bonds, as their portfolios may experience valuation declines. For more stable returns, investors might consider shorter-maturity bonds or fixed deposit alternatives while observing the market for potential shifts in RBI’s stance.

Indian Bond Market’s Expectations on Rate Cut:

The Indian bond market has been awaiting a rate cut, especially in light of actions by other central banks. However, RBI’s refusal to entertain a cut reflects its broader commitment to keeping inflation under control. The market’s anticipation of a rate cut was built on the assumption that India would align with global peers, yet the recent announcement has set a different tone. Investors, therefore, must adjust their expectations, understanding that rate cuts may only come after more significant inflation reductions.

Rate Cut Projections in Light of Global Trends:

With the U.S. Federal Reserve cutting rates by 0.50% in September and the possibility of another rate cut this year, many other central banks have followed suit, creating pressure on economies like India’s to adopt a similar approach. However, given the unique structure of India’s inflation and economic conditions, an RBI rate cut may not materialize as soon as the market had hoped. Most projections now expect the first potential rate cut, if conditions allow, towards the latter part of 2025, after inflation begins showing sustainable declines.

What This Means for Bond Investors:

The absence of a rate cut signals a challenging environment for bond prices, as higher yields translate into lower bond prices. For existing government bonds, particularly those with longer durations, the hardened yields imply a potential capital loss if sold before maturity. However, higher yields make newly issued government bonds attractive for investors seeking better returns in a high-interest environment.

• Market Dynamics: In the short term, bond prices may remain under pressure, with yields staying elevated as long as inflation concerns are unaddressed. For long-term investors, however, this higher yield environment could be an opportunity to lock in attractive rates.
• Government Bonds: Government securities, which tend to be more sensitive to policy announcements, have seen a marked adjustment. The high yields make government bonds more attractive to institutional investors, yet retail investors must weigh the capital loss risks against potential income gains.

For bond investors, the recent RBI stance represents both an opportunity and a cautionary signal. The yield hardening environment can offer improved returns on new investments in bonds, but those holding long-duration bonds may experience short-term capital losses if they choose to sell. Investors looking for secure and steady returns may find the current bond yields more favorable, but those expecting immediate capital gains might need to recalibrate expectations.

Advice for Bond Investors:

1. Invest for Income, Not Capital Gains: Given the likelihood of sustained higher yields, investors should prioritize bonds for income generation rather than for capital appreciation.
2. Stagger Investments Across Maturities: With the bond market still adjusting to RBI’s policy tone, investors could consider laddering bond investments to benefit from different maturity yields and mitigate interest rate risk.
3. Monitor Inflation Data Closely: Keeping an eye on CPI trends will be essential in anticipating any future changes in RBI’s policy direction. Retail investors should stay informed about inflationary developments, as they will influence rate cut decisions.
4. Consider Shorter-Duration Bonds: For those concerned about potential price fluctuations, short-duration bonds may offer more stability while providing exposure to elevated yields.
5. Leverage Bond Platforms: SEBI-registered platforms like Jiraaf provide easy access to a wide range of bond offerings, making the process of bond investing more convenient and transparent for retail investors. Investors should make use of such platforms to arrive at an informed decision.
6. Stay Updated with OIS Rates: Monitoring OIS rates can give investors an early signal of the market’s rate expectations and help in timing investments effectively.

Conclusion:

For bond investors, the current market environment presents both challenges and opportunities. While existing bond holdings may face some pressure, the elevated yields offer income-focused investors a strong proposition. By maintaining an informed view on inflation trends, yield movements, and OIS rate signals, investors can navigate this complex landscape strategically.