Nifty plunged as RBI blinks just ahead of Fed meeting

RBI goes for an unexpected, unscheduled rate hike just ahead of much anticipated Fed hike; RBI may now hike +0.75% in June and +0.50% in August to match Fed

India’s benchmark stock index Nifty closed around 16411.25 Friday; tumbled almost -4.04% as RBI blinks and goes for an unexpected, unscheduled rate hike just ahead of much anticipated Fed hike on 4^th May. RBI stunned the market after maintaining a brave face for the last few months to stay on the sideline despite elevated inflation and faster Fed tightening.

Nifty was already under stress on negative global cues amid the concern of faster Fed tightening and Chinese COVID lockdown. In any way, Dalal Street may have also anticipated to some extent some monetary policy action or jawboning by RBI, just a few hours ahead of the Fed meeting after RBI announced an unscheduled presser by RBI Governor Das. And Nifty tumbled after RBI/Dasannounced +0.40% repo, SDF, MSF, and +0.50% CRR rate hikes without any prior indication or forward guidance to prepare the market.

On Wednesday, the Nifty slumped -by 2.29% after RBI stunned the market with an unexpected and unscheduled rate hike just hours before Fed’s much-anticipated action. But Nifty also recovered from its RBI low around 16623.95 to 16682.65 Thursday after Fed’s less hawkish hike. As highly expected, on Wednesday, Fed hiked +0.50% and indicated further hikes @+0.50% in June, and July. Some market participants were expecting a +0.75% rate hike move in June, July, and September. As a pointer, Fed’s Bullard recently stressed that to control surging inflation and restore Fed’s credibility, Fed needs to hike the rate to +3.50% by Q3CY22 and for that, a rate hike of +0.75% may be required along with active QT (balance sheet reduction).

In other words, Bullard, an influential Fed policymaker is pitching for rate hikes @+0.75% in May, June, July, and September to reach his target of a minimum neutral rate of +3.50% by Q3CY22 from the present +0.50%. Bullard used Taylor’s formula with minimum parameters to reach his recommendation of a minimum neutral rate of +3.50%.

The market was also expecting QT from June @95B/M, but Fed will start the same @47.5B/M from June till August and will increase to $95B/M from September. In his presser, Fed Chair warned Americans about higher inflation and assured them that Fed has the tool to control it. Gold and Wall Street Futures briefly slips, but soon recovered and further surged, when Powell practically ruled out any possibility of rate hikes @+0.75% in the forthcoming meetings. Powell said:

·         A 75-bps rise is not something we are considering

·         There is a consensus that an additional 50 basis point rise should be on the table for the next two sessions

But on Thursday, Wall Street Futures, Gold tumbled, while USD, and US bond yields jumped after the CME Fed Watch tool shows an almost 83% probability of a +0.75% rate hike in June despite Powell’s ‘assurance’ about a +0.50% move. This shows that the market is not taking Powell’s assurance at face value as fine prints of his Wednesday Q&A session do not rule out bigger rate hikes and above +3.00% moves.

Subsequently, India’s Dalal Street also tumbled Friday. Nifty slumped -by 1.63% and closed around 16411.25, before making a session low of 16342.60. So far Nifty plunged around -7.88% in the last four weeks since result season began. Apart from negative global/local cues on the concern of faster Fed/RBI tightening, subdued report card and guidance also dragged the Indian market, slumping 4-consecutive weeks despite some institutional buying support to pop up the market ahead of LICI IPO, India’s biggest so far.

Looking ahead, RBI will follow Fed’s rate action to maintain the policy, bond yield, and FX rate differential; otherwise FPIs may exit further:

RBI tone changed almost 180 degrees in barely 4-weeks just ahead of Fed’s much anticipated +0.50% hike. RBI may have thought that Fed will hike another +0.25% on 4^th May after a similar hike in March. But the reality is that Fed will not only hike +0.50% in May but may also hike at a similar rate in June and July. And now there is a possibility that Fed may also hike +0.75% in June, July, and September to reach a +3.25% rate by Q3CY22.

As highly expected, on Wednesday, Fed hiked +0.50% and indicated further hikes @+0.50% in June, and July. Overall, fine prints of Powell’s statement and Q&A show that Fed will go for +0.50% rate hikes in June and July along with $47.5B/M QT from June-August. If there is no surprise upside in sequential core PCE inflation reading, Fed will hike normal @+0.25% in September, November, and December. Thus combining all these probabilities, Fed may cumulatively hike to +2.75% by Dec’22.

Fed will also hike the QT pace from $47.5B to $95B in September, paving the way for lower rate hikes from September. Total QT in 2022 maybe also equivalent to +0.25% rate hikes (as per Powell’s estimate). Thus US 10Y bond yield is now hovering around +3.00%, the upper range of the Fed’s current estimate of the neutral rate (2.50-3.00%) for the long run, when the economy is ideally around +2.00% inflation and maximum employment.

But Powell also didn’t rule out rate hikes beyond the current estimate of neutral rates; i.e. +3.00%. Powell said Fed will not hesitate to hike further if it sees no sustainable sign that inflation is easing. Fed will hike to slow the economy; i.e. demand, especially both labor and product market, so that the current supply will eventually match it and inflation moderates to around +2.00%.

Powel said although the current spate of elevated inflation is a function of lower supply and higher demand, as a central bank, Fed has the only tool to influence demand, not supply. And Fed is not relying on any Congressional action to ease supply or some resolution on Russia-Ukraine/NATO geopolitical conflict. Thus Fed will do its job, which is to restore/ensure price stability because ultimately it will foster inclusive growth.

Fed/Powell is using Bullard’s jawboning as a forward guidance tool. When Fed is planning to hike +0.50%, Bullard will jawbone for +0.75%. As a result, the market will expect more hawkish Fed hikes, but in reality, Fed will hike by +0.50% as planned. Fed will ensure financial/Wall Street stability in this way besides price stability. If the Fed plans for +0.75% rate hikes, Bullard or someone other influential Fed policymaker will jawbone the market for a +1.00% rate hike and so on.

History shows that despite promising a bazooka, Fed Chair always comes after an FOMC meeting with a water pistol. This time, experienced Powell also used the same strategy and continues to do so for the sake of both price and financial stability. In any way, Fed has to bring down elevated inflation substantially lower before Nov’22 mid-term election; otherwise, Biden may lose his trifecta. Biden may also roll back Trump tariffs on Chinese goods in the coming days to fight inflation back home.

Recent U.S. core PCE inflation data shows that the average sequential rate for February and March is around +0.30% against the 2022 average of +0.42%. Fed is now focusing more on the sequential reading of core PCE inflation rather than yearly for any early sign of easing of price pressure. But even at the sequential rate of +0.3%, the annualized rate would be +3.60%, substantially over Fed’s +2.00% target. Fed needs consistent sequential reading around +0.17% to bring inflation down to the target of +2.00%. Overall, if we consider 2017-2022, till March, the average core PCE inflation was around +2.64% (as per Fed’s average inflation targeting narrative).

In any way, the sequential cooling pace may also indicate that the U.S. inflation may be peaking and the worst may be over. Looking ahead, we may see the sequential rate gradually fall to +0.20%, almost at Fed’s target. Although maintaining price stability is the prime objective of the Fed, it has to also do that without causing an all-out recession. And Fed has to also maintain financial stability besides price stability; i.e. Fed has to ensure Wall Street stability at any cost, especially in an environment of lingering geopolitical tension over the Russia-Ukraine/NATO war/proxy war. The global economy including the U.S. is already under a stagflation-like scenario.

History shows that whenever, the U.S. mortgage rate goes above 4.50-5.50%, it follows an economic recession, be it the 2007-08 GFC triggered by the Lehman Brothers collapse or the 2020 COVID. This time, the U.S. economy already contracted in Q1CY22 sequentially. The market is now also slowly discounting an all-out recession in the U.S. by late 2023 and the launch of QE-5 (along with rate cuts) by early 2024 as a result of faster Fed tightening and lingering proxy war between Russia-NATO over Ukraine.

Fed will carefully go for faster tightening to avoid a hard landing:

History also shows that despite promising a bazooka, Fed Chair always comes after an FOMC meeting with a water pistol. This time, experienced Powell may also use the same strategy. After preparing the market for +0.50% rate hikes from +0.25% normal rates, Fed/Powell may be using Bullard’s jawboning for a +0.75% rate hikes for May, June, July, and September to reach +3.50% terminal/neutral rate by Q3CY22. The market is now also partly apprehending/expecting such faster Fed tightening. But eventually, Powell may hike only +0.50% in June and July, followed by +0.25% each in September, November, and December. This will be seen as a less hawkish hike and risk assets (Equities, Gold and bonds) will recover (relief rally). This way, Powell may also ensure financial/Wall Street along with Main Street stability (lower inflation without a hard landing/causing an outright recession).

Fed has already prepared the market for a neutral rate between 2.75-3.50% by Dec’22 along with QT (balance sheet reduction) @95B/M (a mix of passive and active QT) to control uncontrolled inflation, which is now becoming a major economic and political issue in the U.S. And Fed may hike @0.50% in each meeting of June, and July to reach +2.00% rates from present +1.00%.

Then depending upon the actual geopolitical, economic situation, and inflation/inflation expectations reading, Fed may hike either @0.25% or @0.50% in September, November, and December meeting for the neutral rate of +2.75% or +3.50% by Dec’22. If the actual inflation rate (monthly core PCE) deaccelerates towards the Fed’s goal of around +0.17% from the current average sequential rate of around +0.42% by Aug’22, Fed may slow down the rate of hikes in the latter part of the year from +0.50% to +0.25%; else it will go on with +0.50% rate hikes to reach +3.50% by Dec’22.

Now from Wall Street to Dalal Street, India’s RBI has to follow Fed’s policy action (rate hikes and QT), whatever may be the RBI rhetoric. Although RBI said it does not follow any rule book, in reality, it has to follow the Fed rule book; otherwise, USDINR will appreciate unorderly and there will be unusual outflows. Angel investors will invest in Bidenomics story rather than Modinomics, if RBI fails to keep real bond yield differential (FX risk-adjusted) not attractive enough wrt to US yields.

Although RBI tried to paint a deteriorating macroeconomic situation in the last 4-weeks due to lingering Russia-Ukraine/NATO geopolitical tensions and economic sanctions, in reality, nothing has changed drastically in the last 4-weeks since RBI's last scheduled policy meeting on the 8^th of April. In April, RBI may have hiked +0.25% in line with Fed’s +0.25% hike in March. But RBI stays on hold and goes for only a backdoor hike in the reverse repo with no firm indication of a hike in June.

In India, RBI usually does not actively jawbone/telegraph the market about any possible policy rate action, unlike its U.S. counterpart Fed. RBI may be the only major global central bank in G20, which goes for any drastic change in policy action without any telegraph or attempt to prepare the market well in advance. Thus, Wednesday’s sudden rate hikes by the RBI spooked the Indian stock market and the Nifty tumbled. The market was not prepared for such an unexpected rate hike by +0.40% after RBI’s April MPC meeting barely 4-weeks ago.

RBI may have earlier thought that Fed may hike only by +0.25% in May after March’s +0.25%. RBI may have also planned to match Fed’s anticipated +0.50% rate hikes in March and May by June. But Fed’s tone also changed drastically in the last 3-weeks after Bullard jawboned the market for +0.75% rate hikes in 1^st and 2^nd week of February (after the RBI meeting).

Looking ahead, RBI Governor Das said RBI is now only reversing COVID pandemic era rate cuts. RBI cuts repo rate by -0.75% on 27^th March’2020 to +4.40% in an emergency move (off-cycle meeting) after the Indian Government announced an all-out national lockdown for COVID. RBI also cut the reverse repo rate by -0.90% to +4.00% and CRR by -1.00% to +3.00%. Then RBI further cuts the reverse repo rate by -0.25% to+3.75% in Apr’20 in an off-cycle move. After that RBI further cuts the repo rate by -0.40% to +4.00% on 22^nd May’2020 amid an ongoing national COVID lockdown. RBI also cuts the reverse repo rate by -0.40% to +3.35%. Before COVID, RBI’s repo rate was +5.15% against reverse repo +4.90%. In Jan’19, the RBI repo rate was +6.50% against the reverse repo rate of +6.25%.

As COVID monetary stimulus, RBI cuts the official reverse repo rate to +3.35% against the repo rate of +4.00% to encourage bank lending. The spread was 65 bps against the pre-COVID normal spread of 25 bps, so banks were discouraged to keep excess cash with RBI for a risk-free relatively higher return. Fast forward RBI effectively hikes the reverse repo rate (through SDF) by +0.40% to +3.75% in the April meeting as 1^st strep toward pre-COVID normalization. Then RBI hiked +0.40% repo and reverse repo rate on 4^th April. Now repo rate is +4.40% against the reverse repo rate of +4.15%; i.e. at the pre-COVID normal spread of 25 bps. Also, before the April hike in reverse repo rate to +3.75%, the effective market rate of reverse repo was around +3.75% as RBI was absorbing huge system liquidity through VRRR.

RBI may now also hike rates in line with Fed by at least +2.50% by Feb’23:

Overall, RBI will now tighten in line with Fed not only to control demand and inflation but also to maintain the present bond yield differential (adjusted currency hedge). On 4^th May, RBI Governor Das said RBI reversed the +0.40% rate cut which it did on 22^nd May’20 (during COVID lockdown). Das also indicated next step may be to reverse the +0.75% rate cut, which it did on 27^th March’20. RBI’s next MPC meeting will be on 8^th June, before Fed’s 15^th June. Powell has clearly said Fed will hike @+0.50% both in June and July. In 2022, till June, Fed will hike by +1.25% (assuming a +0.50% hike in June). Thus to match Fed, RBI may hike +0.75% in June for a cumulative +1.25%. In Aug, RBI may also hike +0.50% against the Fed’s possible hike of +0.50% in July.

Powell has also indicated if core PCE inflation eases on a sustainable basis in the coming months, Fed may hike +0.25% in September, November, and December rather than +0.50%. Assuming that holds, Fed will cumulatively hike by +2.50% to reach a neutral rate of +2.75%. Accordingly, RBI may also hike +0.35% in September coupled with +0.25% each in December and February’23 for a cumulative hike of +2.50% (in line with Fed). If Fed goes for +0.50% or even +0.75% rate hikes in September, November, and December, then RBI also has to match Fed.

India’s core inflation is sticky and elevated, consistently much above RBI’s target of +4.00%. India’s core inflation was around +6.3% in March against U.S.'s +6.5% (y/y). Both U.S. and Indian core inflation are elevated and almost at the same levels. Under this scenario, if RBI can’t match Fed hikes, USDINR will appreciate more, causing higher imported inflation, especially since India imports almost 85% of its oil requirement. Indian economy is mainly import-oriented rather than export. Also, the lack of any matching RBI tightening with the Fed, higher USDINR, and the question of RBI credibility to ensure price stability will cause more FPI outflows. India’s 1Y inflation expectation was around +10.8% in March against U.S.'s +6.6%. India’s headline inflation (CPI) was around +6.95% in March against U.S.'s +8.5%.

RBI Governor Das was pursuing a reduction of state VAT on petrol and diesel by non-BJP states. PM Modi also appealed to non-BJP CMs in a recent meeting to reduce state taxes on petrol and diesel. But states are not in a mood to reduce such oil tax as it’s an easy source of huge revenue for them. A state like WB is also demanding huge dues to the tune of almost Rs.97B from Modi (Federal Government) as pending tax dues for any reduction or even abolition of state tax on oil.

The price hikes on fuel began soon after elections ended in Uttar Pradesh and other states- after pausing nearly three months when there was no review despite increasing global oil prices. In late 2021, the Indian Federal Government had cut excise by Rs 5/liter on petrol and Rs 10/liter on diesel to fight inflation. BJP-ruled states have also cut taxes but many other non-BJP states have not.

RBI sources said RBI was compelled to hike abruptly after failing to convince the Modi admin to cut excise duty on petrol and diesel along with certain other supply-side issues. There has been a record Rs 10/liter increase in petrol and diesel prices in a matter of 16 days beginning from 22^nd March, which has further fueled the already high commodity prices.

RBI sources reportedly said: "You should look at this measure as to when it gets tough, RBI stands alone now-- the RBI pleaded, begged, exhorted the government for measures like a further cut in excise duty on fuels which have a direct impact on inflation but could be not managing a response. RBI also asked state governments -- which too impose levies, thus further raising fuel prices -- to follow suit but again did not manage to move the needle. The RBI has said enough and now that the time to act has arisen, it will act alone in its fight against inflation.

RBI will fulfill its responsibility as the debt manager to the government and ensure that the large Rs 14T borrowing program goes through smoothly. One must not look at the borrowing program from its quantum alone, but in context of the GDP--- it has come down to 5% from being as high as 6.8%.”

Although RBI is currently not hostage to any particular rule book, it’s been behind the inflation curve for a long and virtually treating 6.00% of the upper tolerance level as the target instead 4.00%. The Indian economy was already under a stagflation-like scenario (lower economic growth, higher inflation, and higher unemployment) even before COVID. Although RBI never admits it, now it seems that RBI is quite concerned about the stagflation-like scenario because of Russia-Ukraine/NATO geopolitical conflicts, subsequent economic sanctions, and supply chain disruptions. The resultant higher inflation and lower GDP growth may indeed cause stagflation and even an outright recession (after RBI tightening).

It now seems that except for BOJ/Japan, surging inflation is a major headwind for all systematically important global central banks including Fed, ECB, and BOE. Elevated inflation is now a dual issue of higher demand and lower supply. As a central bank has only policy tools to control the demand side of the economy (by tightening), not supply (which is controlled by the administration, Lawmakers, and various geopolitical events). Thus RBI may also control inflation by slowing down the economy/demand through calibrated tightening without causing an outright recession. So far, RBI was unwilling to slow the economy and control inflation as the focus was on growth. RBI believes that there is sufficient spare capacity in the economy and thus ultra-accommodative monetary policy (by Indian standard) is required.

But RBI is now shifting its focus/priority to price stability from growth as uncontrolled inflation will cause lower discretionary (non-essential) consumer spending and eventually result in lower GDP growth. Normally, like all other major central banks, RBI also follows Fed’s actual or even prospective policy action to maintain the real bond yield differential attractive enough, so that angel investors continue to invest in Modinomics (India growth story). But this time, despite Fed hiking +0.25% in March, RBI is on hold in April because the real rate of interest is much lower in the U.S. than in India. But now with faster Fed tightening and surging Indian inflation, the difference between the real rate of interest is decreasing and thus RBI has to act.

As per Taylor’s rule, for India:

Recommended policy rate (I) = A+B+(C+D)*(E-B) =0+4+ (1.5+0)*(6-4) =0+4+1.5*2=0+4+3=7%

Here for RBI:

A=desired real interest rate=0; B= inflation target =4; C= permissible factor from deviation of inflation target=1.5 (6/4); D= permissible factor from deviation of output target from potential=0; E= average core CPI=6

As per Taylor’s rule, which Fed policymakers generally follow, assuming India’s ideal real interest at 0%, the RBI repo/policy/interest rate should be +7.00% against the present +4.40%. Thus RBI may hike to 6.5% by FY23, depending upon the actual trajectory of inflation, which may surge well above +7.00% in the coming days amid higher costs of transportation fuel, and food as-well-as core inflation.

India is already paying around 45% of its core revenue as interest on a public debt against America’s 9%, Japan’s 15%, and China’s 5.5%. Thus India can’t afford too high a bond yield and has to control inflation. RBI has to be ahead of the inflation curve by faster tightening; otherwise, RBI's credibility may be at stake.

Bottom line:

RBI may hike in line with Fed cumulatively by+2.50% at least to reach +6.50% repo rate by Feb’23. And RBI has to improve its communication/thought process in line with practices of major global central banks/Fed to avoid such knee-jerk reactions to the market. Although the Indian bond market may have already anticipated RBI tightening, the equity market was stunned. As the financial market always works with future expectations, RBI has to prepare the market well in advance rather than keeping a ‘secretive’ stance (like in old days).

India’s 10Y bond yield was already hovering above +7.00% since early April amid elevated inflation (as March CPI almost scaled +7.0%) and as RBI hiked SDF/effective reverse repo rate. Now, the 10Y bond yield is hovering around +7.45% against US’ +3.14%. Higher bond yield; i.e. higher borrowing cost is negative for the equity market, especially for interest-sensitive sectors. Although higher bond yield is positive for a bank’s lending model and higher NIM, the demand for the loan at higher borrowing costs will be lower. For most PSU banks, higher bond yield; i.e. lower bond rates will be negative for their MTM bond portfolio. Almost 50% of the EBITDA of PSU banks comes from this bond portfolio.

On 4^th May, after RBI’s unexpected rate hike, USDINR slips to a low of around 75.98, but soon recovered and is now trading around 77.00 on a lack of clear RBI forward guidance about future policy rate actions. The technical chart suggests that USDINR may soon scale lifetime high around 77.15 and even 80.00 levels if RBI refrains from faster tightening to match Fed. Although higher USDINR will be good for exporters (IT, Pharma, and even RIL) and almost 50-60% of Nifty earnings now come from exports, it’s negative for the overall Indian economy as imported inflation will soar; India is an import-oriented economy.

Looking ahead, whatever may be the narrative, technically Nifty Future now has to sustain over 16150 levels for a bounce back to 16550/16625/16850 and 16920/17100 and 17215/17450 levels; otherwise sustaining below 16100-16000, Nifty Future may further slip to 15650-15600 and sustaining below 15600-15475, may further fall to 15375/15000-14850/14400 and 13900-13675/13050-12190/11670 levels in the coming days.

SGX-NIFTY (INDIA 50)

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