For the domestic economy, both headline inflation and core inflation have come down. The gains in core inflation is more significant. Similarly, in the US too, the level of inflation is lower than expected. Is the current inflation data sufficient for a rate cut? Probably not. Central banks will look at the sustainability of these numbers before taking rate action.
Is the inflation gain sustainable? Yes, it looks like. Oil prices, Brent, is stable to lower, and there is no reason why it could move up in the near future. This will have a favourable impact. What about fruits and vegetables? We may see lower prices in the post monsoon period if the spread and coverage of monsoon is normal. Forecasts place the probability for normal monsoons very high. These factors will translate into gains in inflation. The RBI forecast for inflation for Q1 of FY25 is 4.50%. The positive numbers may lead to a rate cut from the RBI and the Fed. This could be, in fact, as early as Sept 24. Why the rate cut is important for the US? The US GDP growth declined from 3.50% in Q4 CY 23 to 1.60% in Q1 CY 24. The unemployment rate has risen from 3.40% to 3.90%.
The inflation control focus of policy has resulted in giving up some growth. This may be important for the US as they move into the election of a new President in Nov 24. Why rate cut is important for the domestic economy? Mainly from the perspective of stimulating rural consumption as rural areas have seen a compression of both nominal and real per capita income, and cheaper credit may be needed to support the recovery. This warrants a cut in the repo rate.
In our assessment the market yields will decline progressively even before the actual rate cut. There is an interesting saying – in rate cuts the RBI follows the market! There are three factors that are giving strong indications of lower rates, apart from the bond index inclusion and the lower govt borrowings.
First, the overnight rate has been trading close to 6.10%. This is much lower than the repo rate at 6.50%. Therefore, the repo rate is not sustainable. Second, the interbank has good amount of surplus liquidity. Third, the Rupee is weaker by about 60 paise – 83.60. Weaker local currency means effectively lower interest rates. Our target on the 10-year benchmark at 6.80% to 6.90% remains intact.
Coming to equities, the lower interest rates are positive for banks and financial institutions. Banks will report higher treasury profits due to their holdings of excess SLR as also their trading positions. Despite RBI trying to buy back bonds from banks there was no success as banks were asking for higher prices. Again, NBFCs who may be borrowing from the markets and not from the banking system will get the benefit of lower rates. The fall in the lending rates will be slower than the fall in the borrowing rates in an interest rate cycle. The benefit that would accrue to mid-caps and small caps will be the highest because their reliance on borrowings for working capital requirements and projects will be higher, though as per a study conducted about a year back the reliance on bank credit of these companies has come down by 25% to 30%. We continue to recommend investments in manufacturing themed ENVI PMS and Gilt Funds.
