Dovishness is in the air

In the last two days, both, the US Federal Reserve and the Reserve Bank of India (RBI) released the minutes for their respective monetary policy meetings. Just to recall, the last MPC meeting for the US Fed was on 30th January and for the RBI on 7th February.

The Fed minutes reinforced expectations that the central bank would be patient in its approach and depending on how the data pans out, could move in the either of the directions - a cut or a hike. Among the risks, the minutes highlighted that the FOMC members discussed the past policy tightening moves and its impact on the economy. They also deliberated on the ongoing trade negotiations between the U.S. and China, and the impact it could have on the US economy.

In what could be perceived as the most appropriate signal of keeping the rates unchanged for the foreseeable future, the FOMC members added that holding the federal funds rate in the current range of 2.25% to 2.5% "posed few risks at this point."

In terms of guidance on the balance sheet size, "almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve's asset holdings later this year.” This could mean that that the US Fed might end its reduction policy before the end of 2019.

Just to recall, the US Fed began reducing its bond portfolio in October-2017 by allowing a capped level of proceeds to roll off each month. Now, the expectations in the market are that the Fed would allow around USD 500 bn more of securities to roll off before the balance sheet reduction is halted. Consequently, the US Fed might end its tightening process when the balance sheet size reaches around USD 3.5 trn. This would be lower than the peak level of USD 4.5 trn achieved during the Quantitative easing (QE) cycle but still much higher than the pre-2008 (recession) level of USD 900 bn.

Meanwhile, on the domestic front, the key takeaway from the minutes of the RBI meeting, released yesterday, was that some more MPC members could join for a rate-cut vote in April. Most of the MPC members believe that there are downside risks to growth and that the outlook for food inflation is expected to be benign in the backdrop of excess domestic supply conditions in many food items. In a nutshell, the minutes reinforced our expectations of one more rate cut by the RBI - possibly in the April MPC meeting.

Vote on the resolution to reduce the policy repo rate by 25 bps to 6.25% 

On growth, all the members agreed that there is a downside risk from the external side in the wake of global slowdown, amidst lingering trade tensions and uncertainty around Brexit. However, as far as the momentum in the domestic demand is concerned, the four members (who voted for a rate cut) agreed that the economy has lost some strength in the second half (moderation in domestic demand as can be gauged through passenger cars, consumer durables, motorcycles and tractor sales) and that there is some level of uncertainty around the prospects of private investment cycle. Dr. Acharya and Dr. Ghate, on the other hand, were somewhat optimistic about domestic demand conditions.

On inflation, concerns of the members who dissented for the rate cut was that “inflation has thus softened but not in a broad-based way”. That is the concern on sticky and high core inflation even as the headline inflation remains low. However, Dr. Acharya mentioned that it is better to “to wait till the next policy” and that in his view “a rate cut decision now would be heavily dependent on the assumption of sustained weak momentum of food prices all through the next 12 months”. This suggests that if the food inflation continue to remain subdued, there is a chance that some of the so-considered hawkish members of the MPC could also vote for a rate cut in the next meeting.

Market implications

The Fed’s stance is positive for the emerging market currencies. This is primarily why the EM currencies have appreciated by around 2% so far this year. However, the dovish stance of the RBI is an offsetting factor for the rupee, as spreads (India vs. US) remain broadly unchanged and hence there is not much for the rupee to gain out of the changing monetary policy dynamics. Add to that, there are uncertainties on the domestic front (elections, rural demand, fiscal concerns) because of which the rupee is not appreciating the way other EM currencies have been this year. Expect this divergence to prevail at least until election results are announced in 2Q-2019.

For the bond markets, external and domestic dovishness (among the central banks) is positive and should lead to a drop in the yields. However, heavy supply of G-Secs (around Rs. 7.1 trn) in FY20 is keeping the pressure intact and limiting the gains that could come in an environment of easing monetary policy. For now, on hopes of a rate cut, the bond yields could remain around current levels and trade in the range of 7.2% to 7.4% (March end). Once the new government comes in and the borrowing calendar takes off, the benchmark 10-year yield in India could inch up to 7.75% by September-2019.

In a nutshell, because of the domestic uncertainties, both the rupee and the Indian bonds are unlikely to enjoy the rally that would have been the case otherwise.