Note to fixed income investors – 07 Feb 2025
Fiscal boost supported by a policy rate cut
The recently announced union budget for FY26 doled out measures to revive the slagging private consumption demand. Particularly, changes in the personal income tax structure are expected to increase disposable income in the hands of tax-payers. This along with focus on improving farm income and employment generation bodes well for revitalising rural and urban consumption demand.
Post the budget announcement, all eyes were on the RBI for supporting growth while remaining focused on bringing inflation down. As expected by the market, the MPC unanimously decided to reduce the policy rate by 25 bps to 6.25% with immediate effect. Consequently, the standing deposit facility (SDF) rate stands adjusted at 6.0% and the marginal standing facility (MSF) rate and the Bank Rate at 6.5%. The MPC also decided to continue with the neutral monetary policy stance and remain unambiguously focused on a durable alignment of inflation with the target, while supporting growth.
The culmination of fiscal measures by the government and monetary policy easing by the RBI should support achieving desired real GDP growth rate. The current growth-inflation dynamics with inflation gradually approaching its target, gave room for a policy rate cut.
In an environment where moderating growth needs due monetary easing support, the flexible inflation targeting (FIT) framework could possibly leave room for further rate cuts in following quarters. However, it would be also dependent on evolving global landscape.
On the liquidity front, in the last two months tightness was largely due to advance tax payments, capital outflows, forex operations and pick up in currency in circulation. However, RBI has announced host of measures such as CRR cut, buybacks, VRR, OMO purchase and currency swap to provide adequate banking system liquidity. Focus on durable liquidity management with proactive measures should help in transmitting policy rate cuts in an efficient manner.
Markets gave a knee-jerk reaction with yields moving up around 5 bps as participants were expecting fresh announcement of liquidity measures for better rate action transmission. The 10-year benchmark G-sec yield hovered around 6.69% post the announcement. Indian Rupee has been under pressure lately, touching all-time low of INR 87.59/USD amid strengthening of US dollar against the basket of currencies and fund outflows. The central bank has been intervening in the forex market to support Rupee by selling USD in a calibrated manner. However, uncertainties around US trade policy pose as a headwind for INR.
The term spread between 3-month T-bill and 10-year G-sec at ~25 bps continues to remain lower than the long-term average term spread of ~130 bps. This is expected to normalize further with improving banking system liquidity. The 10-year G-sec, in the short term, is expected to continue to trade in a range bound manner in the absence of any adverse event.
Strategy for fixed income investor
- With fall in G-sec yields over the last twelve months, our overweight call on duration has played out reasonably well and we continue to maintain our stance in favor for medium to long-term duration. Though the fall in yields have reduced the expected quantum of incremental capital appreciation, there is still a possibility of participation in capital appreciation over the next twelve months with expectation of another policy rate cut. Long-term yield could remain sensitive to the evolving growth-inflation dynamics.
- Corporate bond spreads remain muted with AAA spreads still lower than the LTA amid lack of supply in the bond market. In select instances, spreads for AA and A appear attractive after adjusting for risk. Investor with an appetite for credit risk could start evaluating select high yield strategies.
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