Stay braced for a rate hike

Corporate results this week are likely to be overshadowed by central bank policy statements. The Reserve Bank of India's (RBI’s) Monetary Policy Committee will release its next policy statement on Wednesday while the US Federal Reserve's Federal Open Market Committee will also release its statement on Wednesday (about 12 hours after the RBI due to the time-difference). 

The European Central Bank has said last week that it will maintain its schedule to end its Quantitative Easing (QE) programme by December but not raise currently negative rates.  The Bank of Japan is expected to maintain its continuing QE, and to hold negative policy rates.  The Bank of England has a Brexit headache with stagflation hitting the UK. 

The RBI is quite likely to hike interest rates again, or it may try raising the Cash Reserve Ratio. Inflation is climbing; the rupee is close to its lowest ever levels and the Current Account Deficit is rising. Growth rates are hard to judge due to base effects triggered by GST launch last year. The Q1 results do indicate some sort of expansion in revenues and profits.  

There are serious concerns for the RBI on inflation and currency fronts. Domestic inflation has risen, due to sticky ‘core’ inflation rather than transient factors like food and fuel. Food inflation may decline, given a decent monsoon. Crude price direction is hard to judge since it will depend on geopolitical manoeuvres involving the US and Iran. 

Core inflation is at its highest levels since mid-2014.  The overall Consumer Price Index for June was 5 per cent higher year-on-year. But the core inflation was up 6.4 per cent YoY.  Food and fuel have actually fallen slightly. A look at various core items in the consumer price index suggests however that core inflation is widespread with most items higher.  

The Wholesale Price Index is at 5.77 per cent, which is a four-year high and well above May levels of 4.43 per cent. The differential between the two indices is appreciable and unusual in that the higher WPI suggests that manufacturers have not managed to pass on the rising cost inputs.  This is confirmed by falling margins in the auto industry.  While automobile manufacturers have seen higher sales volumes, they have suffered lower margins, caused by an inability to pass on rising costs.  

The other worry is on the currency and external front. The RBI spent over $21 billion (bn) defending the currency and meeting external obligations between April-June. The rupee has fallen by about 7 per cent since January. It could bounce if crude prices stabilise but the petroleum import bill is projected to be at least 25 per cent higher in 2018-19. 

The Current Account Deficit will be well over 2 per cent, quite likely over 2.5 per cent for 2018-19 - we may assume it will be around $45 bn. External debt obligations this fiscal come to about $220 bn, which is well over half of Reserves of $400 bn. So, the reserves position isn't really as comfortable as it looks at first glance, though it's not alarming.  More rupee depreciation is on the cards - it's up to the RBI to ensure that it's gradual. 

A lot depends on the US Federal Reserve's (Fed) stance. The ECB's tapering of its bond-buying programme will reduce the flow of cheap money into the global financial system.  But the Fed will take money out of the global system if it sticks to an aggressive schedule for Quantitative Tightening: as the existing bond portfolio matures, the Fed will hold till redemption, not re-invest. In addition, the Fed has started hiking rates. 

President Donald Trump has tweeted, publicly demanding that the Fed ease off but it is, in theory, an independent institution. If US second quarter (April-June 2018) GDP data is strong, the Fed will probably maintain its tightening schedules and hike.  If it does slowdown, or signals a less aggressive policy of rate hikes, there will be a relief rally across global bonds and equities. The dollar will also decline, which means a temporary rupee rally. 

Most of the public sector banks have not released their Q1 results. If the non-performing assets’ situation does improve, due to better all round corporate performance, the RBI would have more wriggle room. It would be best to stay braced for a rate hike, maybe accompanied by a hawkish statement.

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