A week after the credit policy was announced on June 6, the financial markets looked quite different from what was expected. Normally when the Reserve Bank of India (RBI) lowers the repo rate there is unbridled enthusiasm with bond yields going down. The talk then centres on how soon banks will transmit the repo rate cuts.
This time the RBI had provided not just a rate cut of 50 basis points (bps) — generally more than what was expected — but also lowered the cash reserve ratio (CRR) at a time when the system was in a surplus of almost `2.5-3 lakh crore on a daily basis. At first sight, this would sound odd as providing liquidity when it was already in surplus would not have made any sense.
However, on deeper thought, the RBI has added certainty in the market by announcing the cut over four tranches post-September. This would also be the beginning of the busy season when demand for credit picks up. Therefore, the rate cut and the reduction in CRR are to be viewed more as a set of measures to tell the markets that the RBI would be providing full support to the system. In fact, it also signalled that the focus would be on growth from now on as inflation is well under control with the annual rate expected to be 3.7%.
This was probably a new approach taken by the RBI, which is refreshing as it blended certainty with surprise. The surprise element was the big-bang impetus of a dual boost through repo rate and CRR cuts. The market should ideally have applauded with bond yields going down. In fact, the 10-year bond should have gone to the 6.15-6.20% level but instead has now gotten into the 6.30%-plus range (going by both the new and old benchmarks). Why should this be so?
A clue to this development is the commentary used in the policy alongside as well as the post-policy interactions with the media. Firstly, the stance which was changed to neutral. While there is nothing sacrosanct in this change given that it can always be altered when circumstances so warrant, a change from accommodative to neutral combined with a large liberal CRR and repo rate cut sent mixed signals. The takeaway was that we should not be expecting any more rate cuts during the year. Second, this view was buttressed by the statement that the committee believed there was less scope for interest rate cuts to push the economy further, meaning thereby that there were limits to which repo rate can influence growth; and this limit may have been attained. This sounds logical because interest rates on their own cannot keep economies running and other factors such as consumption, employment, private enterprise investment, among others, also have to come together.
The bond market has been affected by this decision and articulation. With no signs of further rate cuts in future, the 10-year bond has stiffened even while the T-Bill rates have softened. In the past too, it has been observed that the bond yields tend to be influenced more by what the market thinks the RBI will do rather than what has been done. Often when the repo rate is lowered, and it is fully expected, the bond yields tend to be fairly intransigent even though they would have moved down in advance in anticipation. This is what is meant when it is said that the rate changes have already been buffered by the market.
Another factor coming in the way of bond yields is the state of US markets. While the RBI is clear that it does not take decisions based on what the Fed does, the same does not hold for the market. The market looks at what the Fed says and how the US treasuries are moving. Now, the US 10-year bond is hovering in the range of 4.30-4.50% and moves based on developments on the tariff front.
The Fed has held back rate cuts even though inflation is more or less within acceptable limits. The reason is that the steep tariffs announced are likely to increase inflation which would require the Fed to react. In fact, the balance will be delicate because in the worst-case situation where growth also slows down (though not turn negative to become stagflationary), a more nuanced view will have to be taken. But as of now a long pause till September is expected.
Interestingly, historically the difference between the Indian and US 10-year bond has been in the range of 250-300 bps. Right now the variation is 180-190 bps, which is quite low. This may not have mattered except to academics but for the fact that this differential is important when it comes to investment flows, especially in debt markets. Debt investors normally benchmark returns with the US yields and then make adjustments for currency fluctuations. The rupee has definitely been one of the better performing currencies in the last few years notwithstanding the turmoil witnessed since 2022, which got exacerbated after the US elections and the announcement of the tariff policies.
This differential becomes important in the context of the interest of foreign portfolio investors in Indian debt. The inclusion of Indian bonds in global bond indices was a big positive that was to usher in larger investment flows. One of the factors driving such flows would be the returns and their differential with alternatives. The present differential may not be considered too favourable.
It is normally believed that the debt market reacts with alacrity to policy changes while banks take time to adjust rates. This is so as banks need to evaluate how the lending rates go down as loans linked to the external benchmark get repriced immediately. The marginal cost of funds-based lending rates need to also change, which can come down only if deposit rates are lowered. This is why transmission through the banking system is always with a lag as banks need to evaluate these matrices. The debt market this time has also been relatively less responsive as future actions on the policy front could be uncertain.
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