RBI has Space to Cut Rate Date:   Sunday , January 29, 2017 Headquartered in Mumbai, Quantum Mutual Fund is India\'s First Direct-to-Investor Mutual Fund offers a wide portfolio of top performing Mutual Fund schemes in India through its invest online platform. In November 2016, the Indian bond yield fell to its lowest level since May 2009, as a result of the unfolding of two important events, the victory of Donald Trump in the U.S. presidential elections and the announcement of demonetization of Rs.500 and Rs.1, 000 currency notes by Prime Minister Narendra Modi. Demonetization has added significant liquidity in banking system which raised hope for further reduction in interest rates. However, on 7 December 2016, the RBI has kept interest rates unchanged. The central bank of India has preferred to wait for more data to come which will assist RBI in framing next policy stance. Meanwhile the 10 year Indian bond yields declined from 6.80 percent to 6.20 percent levels due to excess liquidity in the banking system. The total liquidity in the banking system surged due to deposit of Rs.500 and Rs.1, 000 currency notes post demonetisation was Rs.12.44 lakh crore. In the recent monetary policy meeting, the RBI kept Repo rate unchanged. The market had anticipated a 25 to 50 bps reduction in rates. All Six members of MPC (Monetary Policy Committee) voted in favor of status quo, i.e. keeping rates unchanged. U.S. Fed Hikes Rates, Yield Rise Globally, the U.S. Fed interest rate decision was a key event. In policy review meeting, U.S. Fed has raised interest rate and signaled for further rise in rates. Janet Yellen, the chairman of the Fed, described the move as ‘a reflection of the confidence we have in the progress that the economy has made and our judgment that progress will continue’. The U.S. Fed last increased the interest rates in December 2015. U.S. yields moved up by 10 basis points to 2.57 percent levels from 2.47 percent before the announcement of FOMC decision. Donald Trump has promised to increase infrastructure spending and cut taxes during his election campaign. He wants to bring back the money parked by U.S. companies abroad due to higher taxation and stricter regulations. He has promised lower regulations and imposes a nominal tax rate of 10-15 percent on the repatriated money. Owing to lower taxes and higher spending, the U.S. fiscal deficit is expected to increase in the next financial year. The rout in emerging markets led to bond market investors losing $1.7 trillion during November as U.S. 10 year yields moved from 1.83 percent to 2.47 percent levels, as investors withdrew funds from the bond markets due to expectations of hike in Federal Fund rates in the coming months. The Fed policy review indicates the confidence in the U.S. economy. The global bond yield set to rise in 2017 as global economy is expected to grow. However, recovery would be gradual. In its World Economic Outlook (WEO) released in October 2016, the International Monetary Fund or IMF projected 3.1 percent growth for the global economy before recovering to 3.4 percent in 2017. U.S. Fed has signaled for more rate hikes in future which will push global yield upwards. Impact on Indian Bond Market Indian bond yield fell after the demonetization when banks have started receiving lot of cash, however, could not deploy it due to low credit demand. Banks have preferred to purchase bonds which push demand for the bonds and yields started falling. As a reminder, Bond price and yield have an inverse relationship, when one rises, the other falls. The huge liquidity is likely to move out from the banking system when restrictions on withdrawal will be removed. But, not all the cash will go out from the banking system. The demand for the bonds will remain vibrant which would keep yield under pressure. The immediate impact of Fed hike is negative for the Indian bond market but market had anticipated it. The next driver for the bond market is Union Budget which will be announced on 1 February 2017 and the global impact of the policies of the new U.S. President may be felt. Outlook We feel the reason for RBI sitting pat on rates is geopolitical developments which have led to rising risk premium in emerging markets. The November CPI inflation priced at 3.63 percent with core inflation at 4.94 percent. However global markets are very volatile due to FOMC (Federal Open Market Committee) further guidance for the market for the year 2017. Federal Reserve open market committee now sees 75 basis points of rate hike compared with 50 basis points of rate hike guidance given in its September 2016 policy. Global bond markets and currency sold off on the expectations of FIIs outflows from emerging and developed markets to the U.S. Markets. We still expect RBI to cut Repo rate by 50 basis points as we feel the effect of demonetization will significantly affect the Indian economy. We expect RBI to achieve its CPI inflation target of 5 percent which should give space to cut policy rates.