Rate Normalization May be on the Cards

Retail inflation indicated by the CPI for the month of February has touched 6.07 %, and it has come up from 6.02 % for January, and in the last two months inflation has been above the ceiling of the threshold set by the RBI, which is 6 %. The primary factor that has contributed to inflation is fuel price. The prices of food articles have more less remained where they were or contracted a bit. The fuel component will remain the villain of the piece with the crude prices rising to multi year highs after the outbreak of war in Eastern Europe. Though the fuel price has moderated from the highs, it is still lingering around the US$ 100 level. The upward movement in fuel prices started about three months back as the demand for fuel reached the pre-pandemic levels and the OPEC + capacity to expand production and supply was limited. This was bound to take the prices higher. The war added fuel to the fire. This will be an important consideration for monetary policy and a likely reason for any modification to the current stance.

But there are two factors, that may stand in the way of any major policy changes. One, an additional government borrowing program to the tune of `1 lakh Crs has been announced. As you may be aware the program for the next financial year is `14.50 lakh Crs. This kind of a massive borrowing program cannot go through smoothly unless there are clear indications of a stable policy if not an entirely accommodative one. Two, the high fuel prices and the resultant impact on the import costs and the price level, have consequences for economic growth. By general estimates the current fuel prices if sustained for more time, may pull down economic growth by 0.50 % to 0.75% on a conservative estimate. This becomes more pronounced in the face of an otherwise slowing momentum of growth. These two factors will have countervailing impact.
The ten-year benchmark yield has once again touched the 6.90 % level a second time, and it may try to push through its way to higher levels. But the immediate target may be 7.15 % and 7.35 %. A strong support level may be 6.60 %. It may be pointed out here that market yields both at the short end and the long end have moved up in response to expectations on potentially higher inflation and impending changes in official policy. That means some action has already happened, and the rest of the movement could be limited.

The movement in interest rates or rather the rise in interest rates affects the entire spectrum of fixed income assets adversely. The more prudent thing at this time is to stay at the very short end of the curve, that is, in short maturity products. The loss of value on account of a rise in interest rates will be very small or marginal in this part of the curve. Those who are already invested into short term products may hold it because, in a short- term bond portfolio, at least 20 % of the portfolio will be maturing within one year time period, and the fresh investments will be done at the ongoing yields, which obviously will be higher. Also, portfolios invested into such funds may have accrued gains that gives the portfolio some cushion to absorb some short -term pressures. But the key thing to do is to stay at the very short end. At the same time, one should keep an eye on as to when the saturation in yields is going to happen to ensure timely entry into long duration funds, though it is not an easy task to identify this inflection point.



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