The ‘Rajan effect’ and what it means to you

No beating about the bush; it’s cut to the chase, suggests the new RBI Governor Raghuram Rajan’s style of policy review.

The RBI Governor has reinforced that the Central Bank’s key task would be to fight inflation, albeit without hurting liquidity conditions in the finance system. A 25-basis point increase in repo rate even as MSF rate was reduced by 75 basis points and the minimum daily maintenance of CRR was brought down from 99% to 95%, may be seen as a move towards this effect.

Let’s get into the brass tacks of what its impact could be for you.

Impact

• The Governor has stated that the move has sought to reduce the overall cost of funding for banks and therefore there should be enough funding available for productive credit. However, some banks may choose to increase their interest rates if – MSF reduction notwithstanding – their cost of funding goes up.
• The repo rate hike will hurt instruments with long-term maturity such as the 10-year gilt. Soon after the policy announcement, 10-year gilt moved more than 20 basis points to 8.42%.
• The reduction in MSF rates will ease the short-term rates in money markets. That means yields that were stiff in the up to 1-year segment could ease off and more companies can now tap the debt market for short-term funding.

What it means to you

•  The hike in repo rate could result in long-term gilt funds giving up on the 2-2.5% gain they witnessed in the last four days. That means long-term debt funds could give up some recent profits.
• Ultra short-term and short-term funds on the other hand could see a smart rally as the yields of short-term instruments start to slide down.
• T
• he hike in repo rate need not be perceived as being negative to economic growth. It is important to note that such hike is seen as a necessity to stifle inflation. The knowledge of a possibly lower inflation in future could itself be a positive trigger for growth, as stated by the Governor.

What you can do
 

• If you are holding short-term funds then expect a smart rally on those for some time. Currently the difference between MSF rates and repo rates are 200 basis points. The RBI has stated that it would bring this down to 100 basis points. That is possible only if MSF rates trend down further. That means, a further price rally in short-term instruments.

• If you are holding income funds (with portfolio maturity of less than 5 years) with at least a 2-year view then you may see some short-term volatility but hold them as these funds will calibrate their portfolio holding to suit changed interest rate scenario.

• If you have been holding gilt funds for a while now and are on profits, consider moving to short-term debt funds until there is clear signal of interest rates trending down. Repo rate cuts in the near term appear unlikely.

• If you wish to take fresh exposure, avoid long-term gilt funds or funds with a long-term maturity. Focus on short-term debt funds. See our Select funds list under Debt funds 1-1.5 years.

 What’s with equities?

On the equity front, expect continued volatility. SIPs will remain your best bets at this point. You will do well to remain away from interest-sensitive theme funds such as banking for a while.

With short-term rates coming off, companies will be able to directly borrow from the market at lower rates. This will effectively take care of any liquidity crunch and resultant risks with Corporate India’s earnings and Balance sheet, albeit with a lag.

Also, with the U.S Federal Reserve postponing tapering of stimulus, low cost money borrowed in US will likely come into emerging markets that offer attractive valuations.

Hence, Indian markets, together with other Asian markets may well see more foreign inflows. In this case, you will do well to have a firm foot in the domestic market with some diversification in emerging markets as well.

We will soon update you about opportunities in other emerging markets through the fund route.

 Going forward we see the following factors determining any further moves by RBI: 

–          Impact of monsoon on food price inflation.

–          The movement of the rupee, in light of the recent inflows of $1.4 billion (in the last 4 days ending Thursday) brought in by banks through the FCNR(B) route and swap facility

–          Movement of global commodity prices, given that postponement of Fed tapering could cause asset price distortions