Domestic Bonds

impact on inflation: Inflation reaches its highest level in 8 years! Here’s what that means for the economy, stocks and bonds

NEW DELHI: For those wondering why the Reserve Bank of India showed the degree of urgency it did when it raised interest rates in an unanticipated move last week, the latest data on inflation provide a clear answer.

Headline retail inflation in India soared to an 8-year high of 7.79% in April, according to data released yesterday by the National Statistics Office.

While announcing the rate hike after an unscheduled meeting of the Monetary Policy Committee last week, RBI Governor Shaktikanta Das warned that April inflation would be high, but the extent to which the indicator for consumer prices rose last month exceeded expectations.

A Reuters poll had put consumer price index inflation at an 18-month high of 7.50% the previous month.

As things stand, it is now pretty much a given that the RBI will follow last week’s rate action with another rate hike in June. The question, however, is by how much?

Das had said last week that the prolonged accommodation reversal process at the start of the COVID-19 crisis began with the 40 basis point hike on May 4, which took the repo rate to 4, 40%.

Given that the repo rate was cut from 5.15% to a record high of 4% in 2020, interest rates would need to be raised another 75 basis points to reverse the rate cuts from the pandemic era.

But, given the scale of soaring inflation and tightening global commodity prices that keep upside risks to inflation elevated, markets are abuzz with speculation that the central bank may have to raise rates by well over 75 basis points in the future.

said in a note last week that he expects the repo rate to be raised by 60 basis points in June, followed by 50 basis points each in August and October and 25 basis points at each meeting thereafter until June 2023, eventually raising the repo rate to 7%.

Although this prediction is one of the most aggressive, analysts are more or less united that the repo rate will rise almost 100 basis points from current levels.

What does this mean for the economy?
Finance Secretary TV Somanathan told CNBC

India’s economic growth rate is likely to slow if the central bank raises interest rates.

It should be noted that the statement from the Ministry of Finance comes at a time when the RBI is just beginning the process of raising rates.

While Das himself acknowledged last week that rate hikes would impact output, the central bank chief also said an unanchoring of inflation expectations would negatively affect economic growth.

There is no doubt that the erosion of purchasing power has begun to weigh on economic growth as individuals realign their spending habits in the face of rising prices for a wide range of consumer goods.

Higher interest rates and therefore tighter financial conditions are impacting aggregate demand in the economy, but the central bank may have no choice but to tackle the bull of the inflation through the horns.

On Wednesday, Morgan Stanley cut its forecast for Indian GDP growth to 7.6% from 7.9% for the current fiscal year and to 6.7% from 7% for the next fiscal year.

“The main channels of impact are likely to be higher inflation, weaker consumer demand, tighter financial conditions, the negative impact on the business climate and a delay in the recovery of investment,” the company said. world.

This follows recent cuts to India’s growth forecasts by several other organizations, including the International Monetary Fund, the United Nations Conference on Trade and Development and foreign bank UBS.

How would stocks react?
The prospect of further sharp interest rate hikes and further steps to remove excess liquidity from the banking system does not bode well for domestic stock markets, which since last week have been reeling from a hawkish turn without ambiguous national and foreign central banks.

The RBI is almost certain to accompany rate hikes with more increases in maintaining the cash reserve ratio for banks, which would suck excess funds from the banking system.

The RBI’s huge pandemic-era liquidity injections into a historically low interest rate regime was a key factor in pushing Indian equity markets to all-time highs in 2021.

As markets now grapple with the dreaded combination of rate hikes and slowing growth, analysts have questioned Indian equity valuations as FIIs continue to sell domestic equities at an all-time high in a context of sharp rate hikes in the United States.

The Nifty and Sensex have both fallen around 4% since last week and technical indicators suggest more pain ahead.

The recent spike in government bond yields will make matters worse by posing a clear threat to equity valuations, analysts said.

“The general rule is that the higher the risk-free rate of return (government bond yields), the higher the discount rate modeled in the DCF – the discounted cash flow model on which the fair value of all action is determined,” independent market analyst Ajay Bodke said earlier this week.

The market analyst warned that leveraged companies and those with large cash flows far away could be disproportionately affected.

Consequently, so-called growth stocks, whose valuations include long-term cash flows, could suffer.

No respite for obligations
The government bond market, which represents borrowing costs across the economy, has recently seen a bloodbath as the RBI’s urgency to catch the inflation curve took the market by surprise.

The yield on the benchmark 10-year government bond has jumped 79 basis points so far in 2022 and analysts are expecting a much bigger upside. Bond prices and yields move in opposite directions.

While reports quoting sources said the government was unhappy with the recent surge in gilt yields, the fact remains that the RBI has very little room to manage bond yields as it has these past few years. last two years.

As the government announced a massive and unprecedented gross borrowing program for the current year, bond traders lamented a severe mismatch between demand and supply for sovereign paper.

At a time when it is raising interest rates and actively draining excess liquidity, the RBI cannot step in as a major bond buyer and maintain a cap on yields because such acquisitions by the central bank lead to adding sustainable liquidity to the banking system. .

“We expect the 10-year yield to be around 7.40% by the end of the month, the trajectory for yields will be up,”

Naveen Singh, Head of Trading at Master Dealer, told ETMarkets.

“Thanks to the non-policy rate cut, the RBI has signaled its intention to act quickly on inflation, so I think there will be a 50bps rate hike in June. 75 bps might be overkill and 25 bps would be a stray bullet, so 50 bps is the expectation.

The obvious result is an increase in borrowing costs across the economy – from companies tapping into the bond market to individuals whose loan pricing is tied to sovereign debt products.