The new financial year has started with the Reserve Bank announcing its first bi-monthly monetary policy statement. As widely expected, the RBI left interest rates unchanged. The RBI also reiterated its earlier guidance that as long as inflation follows its guided path towards 8% by January 2015, further rate increases are not anticipated. With this statement and the previous policy statement two months ago, the RBI has broadly indicated that the current rate hike cycle (Sept 2013 to Jan 2014) has come to an end, and in case inflation proves to be sustainably below the indicated path, there would be scope for easier monetary policy in the months ahead.

The outlook for interest rates is therefore contingent on the evolution of inflation. The CPI basket is roughly equally split between food and non-food items. At the moment, both components are at about the 8% mark, with the food component having substantially reduced from 12.5% back in November. The spike in food inflation last year could be largely attributed to two factors: large increases in minimum support prices (MSP) of key crops and a spike in vegetable prices following unseasonal rains. Vegetable prices have moderated in the last three months, while the much smaller MSP increases for the current crop year have contributed to moderation of the remainder of food inflation. Thanks to these factors and the strong base effect CPI inflation for the remainder of the current calendar year is likely to be well below the RBI projection of 8%.

In this RBI cautions that they would need to look past any transient moderation and look at the underlying trend. The trend for food inflation next year would be determined by the quantum of MSP increases and the fate of the monsoon this year. We would have a better sense of these factors over the next three months.

Non-food inflation (or more specifically non-food, non-fuel inflation known as core inflation) has remained sticky near 8% for the last several months. There is some evidence to suggest that core inflation is affected by currency movement. That is, a trend of depreciating currency leads to higher core inflation while currency strength leads to lower core inflation. The recent strength of the Indian Rupee thus gives rise to the hope that core inflation too will moderate in the months ahead. About a quarter of core inflation is house rents, which are measured by changes in House Rent Allowance. In turn HRA is linked to CPI. If headline inflation moderates this year, next year?s HRA increases should be lower, leading to lower core inflation.

Assuming a normal monsoon and without any inordinately large increases in crop prices we should expect to see RBI meet its inflation objective this year with a trend towards meeting its January 2016 target as well. This is significant for RBI to rebuild its inflation fighting credentials. Over the past six years, CPI inflation has remained close to double digits. High inflation has been a major contributor to macro-economic instability through reducing purchasing power, savings rate and competitiveness, and consequently increased the current account deficit culminating in the near currency crisis we faced last year.

In the past the RBI and the bond market have focussed on Wholesale Price inflation (WPI) as the key measure of inflation. Consequently between 2010 and 2012, while WPI inflation remained on average at 8%, bond yields (10-year benchmark government security) traded in the range of 8.3-8.8%. Late in 2012 and in early 2013, WPI inflation eased sharply to under 5%. This period saw bond yields fall to about 7.2%. With the current focus on CPI inflation rather than WPI inflation the market has ignored the sharp fall in WPI inflation which is currently at 4.7% (Feb 2014). Bond yields at 9% reflect the CPI at 8.1% today. As CPI inflation decreases we would see bond yields drop. As RBI regains credibility in fighting inflation, i.e. as inflation trends towards 6%, we should see bond yields drop significantly over the course of the next 12 months. Bond prices are inversely correlated with yields and thus we expect that the coming year should see significant gains in long term bonds.

Will Fed tapering affect bond market?

Last year?s currency and bond market shock could be at least partly attributed to the US Federal Reserve?s anticipated reduction of its quantitative easing programme (tapering). Several emerging market currencies fell sharply and interest rates and bond yields rose. The rupee was one of the worst affected currencies though the bond market was less affected than peers. One important reason that the rupee fell sharply was the large current account deficit in late 2012 (above 6% of GDP at its peak). Now though the current account gap has been reduced to under 2% of GDP?a sustainable level. In addition, the RBI has added to its foreign exchange reserves, which enable it to tackle exchange volatility better. Both these factors explain why the rupee has appreciated in 2014 while many other emerging markets have seen their currencies fall after the announcement of tapering in December 2013.

It is also pertinent to remember the last time the US embarked on a tightening phase of monetary policy from ultra low interest rate levels starting in 2004. Then, as now, the Fed tightened based on its judgment that the US economy was improving. It is interesting to note then that the following three years (2005-07) saw a period of rupee appreciation, current account surpluses (instead of deficits) and a broadly stable bond market.

Opportunities in bond market

Falling inflation will allow RBI to cut rates over the course of the next four-six quarters. This will allow bond yields to fall and provide an opportunity to invest in rising bond prices. Investors with an investment horizon of 12-18 months or longer should look to invest in long duration income and dynamic bond funds. In the very near term (three-six months), it is possible that market volatility could be high ?thanks to the elections and new budget, and the onset of the monsoon. Investors with an investment horizon of three-six months should look to short-term funds as these funds are much less volatile than long bond funds.

R Sivakumar

The author is head- fixed income, Axis Mutual Fund