The US Fed expectedly raised the benchmark rate by 25 bps (100 bps = 1.0%) to 5.0% - 5.25% target range in the May 2023 FOMC meeting. While the FOMC’s latest statement omitted the prior language that signaled additional hikes ahead, the Committee indicated that it would monitor the extent to which more firming would be appropriate would hinge on the lag effect of the past cumulative rate hikes on economic activity and inflation and economic and financial developments.
Importantly, the FOMC’s inflation forecast outlook does not support rate cuts in 2023, and thus gap between the US Central Bank stance and market expectations continues to be a significant risk.
The ECB followed with a smaller 25 bps rate increase in May 2023 and indicated further increases to make rates sufficiently restrictive.
The RBI surprised the markets by choosing to pause in the April 2023 MPC meeting. Supportive base effect and recent softening of crude prices indicate that the RBI will keep the repo rate unchanged in the June 2023 MPC meeting.
Indian markets are pricing a cumulative 80 bps of repo rate cuts over the next 1 year, with the first cut expected within 3 months. With the RBI reiterating that policy target for inflation remains 4.0%, we feel the markets are running ahead of expectations.
We have moderately increased the maturity across the duration portfolios by increasing allocation to benchmark government bonds. We will look to tactically add duration on dips, but will increasingly remain watchful of signs which could belie market expectations and nudge them towards the Central Bank stance.
We expect 75 bps of cumulative rate cuts by end 2024 with the first reduction by early 2024. Taking this into account, duration funds are expected to deliver superior risk adjusted returns as compared to non-market linked fixed rate products.