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Monetary policy: Expect yield curve to start to steepen overtime

Monetary policy, market expectations, Q1 GDP, WALR, Liquidity, SDL supply

By Suyash Choudhary

The monetary policy committee (MPC) voted to cut repo rate by 25 bps to 5.15%. The decision to cut was unanimous although one member wanted a larger 40 bps cut. This is largely in line with market expectations.


Global growth slowdown continues and the recent supply-shock driven crude oil spike has unwound faster than expected. Domestically, the drastic slowdown in Q1 GDP has been followed by softer higher frequency indicators.


Notably, monetary transmission has remained "staggered and incomplete". As against cumulative policy repo rate reduction of 110 bps during February-August 2019, the weighted average lending rate (WALR) on fresh rupee loans of commercial banks declined by 29 bps. However, the WALR on outstanding rupee loans increased by 7 bps during the same period.


The governor explicitly clarified that the recently released liquidity framework report is a work of an internal working group that has been now put up for public comments, and does not reflect the institutional position of the RBI. This is important as the report had been generally found to be underwhelming, breaking little new ground or even acknowledging any meaningful shift in thinking with respect to targeted quantum of liquidity in the system. The clarification is a relief and the market may continue to believe that stance remains of adequate positive liquidity premised on the old adage of actions speaking louder than words.


This policy re-emphasises the important break that the RBI governor has executed from the past: the full deployment of all three pillars of rates, liquidity and guidance. The guidance is the strongest yet with the MPC deciding to continue with an accommodative stance as long as it is necessary to revive growth, while ensuring that inflation remains within the target.

Thus while we may be closer now to the terminal rate in this cycle, investors need to focus on the other more important aspect: that barring an unforeseen global development it is very likely that the policy rate remains around the 5% mark for an extended period of time. The same interpretation will likely hold for the stance around ensuring abundant positive liquidity as well.

This will mean that front end rates remain very well anchored. Investors may need to shift focus from looking at only potential mark-to-market gains from falling rates to looking towards 'receiving' the steepness in the curve built into the front end versus the immediate overnight and money market rates.

Long duration

For long duration (10 year and beyond) the term spread will also be influenced by supply dynamics. There are two points to ponder. One, the potential fiscal risks that may manifest for the Centre thereby translation into additional bond supply. The current second half calendar is slated to end by January, thereby providing enough time for extra borrowing. We are anticipating a 40 bps slippage to the deficit target, although this entire slippage may not translate into equivalent borrowing.

However, the current net supply of government bonds is quite smaller compared with the first half. Secondly, the bigger worry pertains to state development loan (SDL) supply. We are expecting gross SDL supply to touch close to Rs 6 lakh crore in the current financial year, almost 30% higher than last year.

We would expect the yield curve to start to steepen overtime. This is reflected in our preference for 5-7 year government bonds in our active duration funds. High quality short term products also look attractive in this backdrop. We remain cautious on credit where valuations are still not being backed by narrative.

The writer is head, Fixed Income, IDFC AMC