The Reserve Bank of India took the bond markets by a surprise as it reduced the repo rate by 0.50 per cent to 4.50 per cent on Saturday. Before this, the repo rate was brought down from 5.50 per cent to 5 per cent in March 2003. And after a bank rate and CRR cut in April 2003, markets had been expecting a 0.25 per cent cut in the repo rate. But the apex bank in its review of Monetary Policy in April 2003 had stated that the movement of inflation and level of monsoon would decide the future course of interest rates. Most players were in fact expecting any decision on this in October.
But inflation has fallen from 6.7 per cent in April to 3.95 per cent and the monsoon has been adequate and so the much-anticipated rate cut has come earlier than expected.
Yield on the benchmark 10-year government bond dropped 0.21per cent from Friday's level of 5.56 per cent. At the time of writing, it had fallen to 5.34 per cent. On the contrary, the bond prices had fallen (rise in yields) on Friday following the RBI's comments that it is closely monitoring a flat yield curve. The repo rate cut may indeed lead to a steeper yield curve as the yield on short-medium maturity instruments are likely to fall more than the long-term ones. For instance, since Friday, the yield on 5-year gilt has dropped 30 basis points while the 15-year gilt has barely moved from its Friday's close. (as per latest available yields on rbi.gov.in)
Implication for Fixed Income Investors
Repo rate is the rate at which RBI borrows from banks for short-term, so there is no immediate impact on the assured returns products like bank fixed deposits. However, banks may go in for the deposit rates cut in the coming days.
As yields fall (i.e., bond prices rise) at the shorter end of the curve, investors in short term debt mutual funds should benefit. However the new investors entering now, may fetch lower returns, as their money will be invested at lower interest rates.
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