Interest Rates & Yields

2017 opened with expectations of continuing in the trajectory of falling interest rates. However, RBI took the markets by surprise by shifting the monetary policy stance from accommodative to neutral in early February. The reserve bank has reiterated and reinforced this stance ever since. The interest rate was cut only once by 0.25% during the October policy on account of persisting low inflation.

The 10-year Government Security had a roller-coaster ride this year. Yields rose sharply when the policy stance moved to neutral. On the contrary, there was barely any movement, when interest rates were lowered in October. The yield has been on a steady rise from August this year. The rise has been supported by the RBI’s OMO operations, neutral policy, and rising interest rates in the United States.

Demonetization & Inflation

This year witnessed the after-effects of demonetization, manifested in the form of excess liquidity. The RBI has worked consistently to absorb the excess liquidity. Currency in circulation has been restored to its pre-demonetization levels. Improving GDP and industrial production numbers in the last two quarters has allayed slowdown concerns.

Inflation appears to be the lynchpin. Monetary policy actions hinge on the movement of inflation rates. The CPI index reached a concerning low of 1.54% in June this year. Over the past few months, inflation has climbed due to rising food and fuel prices, geopolitics, and increasing global liquidity.

US Bond Markets

This year, the Fed has raised rates by 25 basis points each in March, June, and December. The interest rate now lies in the band of 1.25% to 1.50%. Falling unemployment and improving economic growth in the US have supported these rate hikes. The overall expectation is that the Fed will continue to raise interest rates in the coming year as well. The passing of the tax reforms will speed up this process. Jerome Powell is set to replace Janet Yellen as the Fed Chair in 2018.

Market Outlook

2017 favoured Indian equities. To such an extent that money meant for debt flowed into equity, mostly in the form of balanced funds promising regular payouts. This is not a healthy trend for financial markets.

A rate hike is more probable than a rate cut in the current scenario. Keeping this along with neutral policy in mind, it is important to maintain quality in the investment portfolio. As the fixed income space has a return ceiling, it is important to align to high-quality accrual funds that can ride through volatility and protect the portfolio from downsides.

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