By changing its monetary policy stance from ‘accommodative’ to ‘neutral’, the RBI surprised the market in February. The RBI surprised the market again last week by reducing the gap between repo and reverse repo rates.
The repo rate is the rate at which RBI provides short-term liquidity to banks and reverse repo is the rate at which RBI allow banks to park funds with it. What does this reduction in gap mean?
“This narrowing of policy rate corridor is to better align other money market/call rates to the formal policy stance,” says Radhika Rao, India Economist, DBS Bank. RBI wants the short-term rates to remain close to the repo rate of 6.25%. However, due to demonetisation induced excess liquidity in the system, actual rates were trading close to the reverse repo rate of 5.75% and even 3 months papers were trading at 5.86%.
RBI has announced its intention to maintain a neutral stance on liquidity front, meaning it will slowly drain out the excess liquidity through instruments like MSS bonds, cash management bills, reverse OMOs, etc. Though excess liquidity has come down from Rs 7 lakh crore in January, it is still high.
“Excess liquidity in the system is still at Rs 4 lakh crore and RBI has to drain this out. RBI may keep the liquidity situation slightly in deficit so that the market rates come close to the repo rate of 6.25%.”
The debt market got the message and reacted negatively. Long duration papers fell and yields went up. Long duration income and gilt funds also reported huge losses on April 6. Since the rate is expected to harden further, experts want you to stay invested in short duration funds.
The reason: “Rate cutting period is over and we are in a neutral zone. We may be heading to a rate hiking cycle (after 3-4 quarters). Consider long duration bond funds only when 10-year yield comes close to 7.5%,”