Macroeconomic assessment:
In recent times, the Indian economy has been confronting with risks. The economic growth rate has dwindled and the slowdown seems rather worrisome in the backdrop of contraction in industrial activity (mainly led by manufacturing). Moreover, with the lead indicators of services also signalling a subdued outlook (barring some uptick in transport and communication activity), it is expected that GDP growth rate in Q3FY2013-14 would lose momentum. Fortunately, agricultural performance has so far been robust, and the strong pick-up in rabi sowing indicates that this should be sustained.

Another gravest risk emanates from CPI inflation (which has remained closed to double-digit terrain), which also has a bearing on the value of the Indian rupee. This is because elevated levels of inflation erode household budgets and constrict the purchasing power of consumers. This, in turn, even discourages investments and weakens growth. And inflation is also a tax that is grossly inequitable, falling hardest on the very poor. Thus it is only by bringing down inflation to a low and stable level, that monetary policy can facilitate revival in consumption and investment activity in sustainable way.
 

Headline inflation

Data as on December 2013
Source: Office of the Economic Advisor, PersonalFN Research)  

Although headline inflation has fallen significantly with the substantial fall in vegetable prices, CPI inflation excluding food and fuel has remained flat and WPI inflation excluding food and fuel has risen. Hence the Reserve Bank of India (RBI) has said, the so-called trade-off between inflation and growth is a false trade-off in the long run. But it is of view that it is possible to bring inflation under control without a substantial sacrifice of short term growth, provided it does what is necessary, and is patient.

A silver lining though to the gloomy clouds of economic slowdown and inflationary pressures is that, trade deficit has narrowed down significantly on the back of resilient export growth. Therefore, now the Current Account Deficit (CAD) is expected to be below 2.5% of GDP as compared with 4.8% in 2012-13. The recent resumption of capital inflows should help finance the current account deficit comfortably. Reserves have been rebuilt since September 2013, and are expected to increase further as oil marketing companies, that have been buying foreign exchange in the market, to repay the Reserve Bank when their swaps come due. But given the external environment, pressing a pause button, in RBI's view would be incorrect in the on-going effort to ensure fiscal and monetary stability.

Monetary Policy Action...
Hence in the backdrop of the aforementioned macroeconomic assessment, it was decided by RBI as under:

To increase the policy repo rate from 7.75% to 8.00%; and

To increase the reverse repo rate from 6.75% to 7.00%

Thereby maintaining the Liquidity Adjustment Facility (LAF) corridor between the repo and reverse repo rate at 100 basis points (bps). However the Marginal Standing Facility (MSF) rate and Bank Rate stood adjusted to 9.00%.

To keep the cash reserve ratio (CRR) of scheduled banks unchanged at 4.0 per cent of net demand and time liability (NDTL).

What does the policy stance mean and its impact?
The repo rate is the rate of interest charged by the central bank on borrowings by the commercial banks. Increasing it by 25 bps would infer borrowing cost of commercial banks will increase. Hence as a reaction to such a move cost of borrowing for individuals and corporates may also elevate, thereby making home loans and car loans expensive.

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Increasing the repo rate will imply that commercial banks would fetch a 25 bps higher rate as against earlier, for parking their surplus funds with RBI.

The Cash Reserve Ratio is the amount of liquid cash which the banks are supposed to maintain with RBI. Keeping it unchanged would not infuse further primary liquidity into the banking system. Likewise keeping the MSF rate would not infuse short-term liquidity in the system.

Guidance from monetary policy and path for interest rates:
It is noteworthy that the RBI has indicated (in the Review of Macroeconomic and Monetary Developments for Q3 of 2013-14) that inflation is expected to moderate gradually but stay above the RBI's comfort level. Upside risks to inflation in 2014-15 arise from likely upward revisions in domestic energy prices and growth acceleration. However, global commodity prices, especially for metals, are expected to remain soft and partially. The central forecast for CPI inflation is 8.00% and if disinflationary process evolves according to this baseline projection, further policy tightening in the near term is not anticipated at this juncture. In fact, if inflation eases at a pace that is faster than we currently anticipate, and that reduction is expected to be sustained, the Reserve Bank will have room to become more accommodative.

Impact on debt markets...

Since markets were expecting the RBI to maintain a status quo on account of drop in headline inflation as well as retail inflation for December 2013, the policy rate hike was a surprise for the debt markets and thus the yields across the maturity curve inched-up, but some recovery was seen due to a dovish tone in the guidance. However the balancing act between growth and inflation remains to be seen, now that focus seems to be turning on CPI inflation. While the pressure on CAD is possibly receding, the fiscal deficit seems to be yet a concern (although the finance minister, Mr P. Chidambaram is belying the worries) as it has already run-up 93.9% of the budgeted target of Rs 5.42 lakh crore in the first 8 months of the present fiscal year. Hence going forward, the longer end of the yield curve seems to be exposed to more risk than the shorter end.

What strategy should debt investors should adopt?

So in the aforesaid backdrop, PersonalFN is of the view that, it would be best to refrain investing in longer maturity debt papers, and instead prefer shorter maturity debt papers. If permitted by your time horizon and risk appetite if you still want to invest in long-term debt funds, it would be wise to take exposure via dynamic bond funds (as enabled by their mandate they hold debt instruments across maturities). But PersonalFN thinks that given the aforementioned interest rate scenario and macroeconomic variables thereto, one should not hold more than 20% of their debt portfolio in longer tenure funds. Avoid investing in G-sec funds, as they may see high volatility and may not be an ideal instrument to yield fruitful returns. Fixed Maturity Plans (FMPs) of 3 months to 1 year period can also be considered as an option to bank FDs only if you are willing to hold it till maturity. Alternatively you can also invest in 1 year Fixed Deposits (FDs), as banks are offering interest on 1 year FDs in the range of 8.00% - 9.00% p.a. In the present scenario, it would be ideal to invest in shorter duration instruments vide debt mutual fund schemes having shorter maturity profile. Investors with an extreme short-term time horizon (of less than 3 months) would be better-off investing in liquid funds for the next 1month, or liquid plus funds for next 3 to 6 months horizon.

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