In a surprise move, RBI lowered borrowing rate on Marginal Standing Facility (MSF) by another 0.50% on Monday. The rate was reduced by 0.75% for the first time at the second quarter mid review of monetary policy. After these reductions now the MSF rate stands at 9.0%. Equity and debt markets have reacted positively to this development as tide seems to be turning now. Few weeks ago, the MSF rate was hiked by 200bps or 2.0%. In a drive to stabilise rupee and curb speculation arising due to excess liquidity in the system; RBI had hiked short term borrowing rates. But this had put enormous burden on banks to meet their short term liquidity needs.

What led RBI to reduce rates now?
Rupee has bounced back nearly 11% from the lows it recorded towards the end of August. RBI may be of the view that now rupee would stabilise since Federal Reserves in the U.S. is likely to delay the tapering of Quantitative Easing (QE). In the past, speculation about winding down of QE3 had caused dollars to flow out from emerging markets. Indian rupee took a hit due to heavy dollar outflows. Although the Current Account Deficit (CAD) has widened to 4.9% in the first quarter of Financial Year (FY) 2013-14; it is significantly lower than record high of 6.5% witnessed during October-December quarter last fiscal. In sync with steps taken by the government, RBI initiated some measure to attract flow of foreign capital to India which may help India improve its Balance of Payment (BoP) position in future.

How various asset classes have reacted to this move by RBI?
When the short term borrowing rates were hiked for the first time on July 17, 2013; debt markets had reacted negatively. Yields on short term instruments skyrocketed and impact was also felt on the securities with longer maturities. Banking shares also witnessed selling pressure. But now with partial reversal of the MSF rate; the market sentiment has improved a bit and yields have dropped.
 

Volatility in yields... (Source: Fixed Income Money Market and Derivatives Association of India, RBI, PersonalFN Research)  

As expected, instruments with short term maturities have borne the highest impact of the recent cuts in MSF rates. As depicted in the graph above, over last one month movement of yield on 10 year G-sec benchmark bond has been relatively flat but yields on 1-month Certificate of Deposits (CDs) and 3-month CDs have dropped substantially. Banking shares also staged relief rally but sustainability still remains a question.

Although the central bank has been reducing MSF rates, it hiked the repo rates. Lowering of MSF rates suggests that the rupee volatility may now be in the comfort zone of RBI. But Repo hike shows its discomfort with climbing inflation. Recently, finance ministry decided to infuse capital in PSU banks. This fresh capital would be utilised towards granting consumer loans at concessional rates to spur demand thereby putting upward pressure on inflation. PersonalFN is of the view that, RBI may further lower MSF rates but may consider repo hikes again, if needed. Lower MSF rates would help ease pressure on short term yields. Liquidity worth Rs 40,000 - Rs45,000 injected by way of government spending would help liquidity crunch. Moreover, the RBI may allow banks to borrow upto 0.25% of their Net Demand and Time Liabilities (NDTL) through term repos having maturity of 7 and 14 days. Also, cash management bills which were issued to suck out liquidity from the system a few weeks ago are maturing in the near term. This would release another Rs 52,000 crore in the system and would have a positive impact on yields of short term instrument. On the other hand, long end of the yield curve would be affected with several factors such as inflation and fiscal deficit to name a few.

PersonalFN believes that current market conditions are uncertain and it would be extremely risky to speculate on the movement of interest rates, going forward. Short end of the yield curve still appears attractive as compared to the long end. PersonalFN is of the view that, you should consider your financial circumstances and time horizon before investing in debt funds as they are not risk free. Moreover, long term debt funds should not account for more than 20% of your debt portfolio. Selecting a debt fund is as crucial as selecting an equity fund.

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