What you should know about rate cuts this year

The market is gearing up for a likely interest rate reduction cycle in 2024. Here's a closer look at the scenario. Firstly, it is anticipated that inflation will soften, with the Consumer Price Index (CPI) projected to average at 5.4% in 2023-24, according to the Reserve Bank of India (RBI). Although these predictions are slightly above the central bank's 4% target, they reflect a declining trend. Secondly, while India's GDP growth remains robust, it could benefit from lower interest rates. Furthermore, a similar easing cycle is expected soon in the two largest economic blocks, the USA and the Eurozone, while China is already reducing interest rates.

The easing cycle is expected to begin in India in the second half of 2024. The Federal Reserve in the US has signaled, through the 'dot plot' used to communicate future rate projections, that policy rate reductions will begin in 2024. The European Central Bank is also easing its economic outlook. However, the RBI maintains a 'withdrawal of accommodation' stance, which lies somewhere between neutral and hawkish. This stance would need to transition to neutral for rate cuts to commence, which is anticipated to occur when CPI inflation aligns more closely with the 4% target. Majority approval from the six-member Monetary Policy Committee is also required, which is expected to happen in the first half of 2024, paving the way for rate cuts in the latter half.

The upcoming rate cut cycle is predicted to be minor, with expectation for reductions within the 0.5-0.75% range, leaving the repo rate at 5.75% or 6%. This allows for a safety buffer in case future inflation exceeds expectations.

Predicting how yield levels will respond is risky, given their potential for short-term volatility. However, over the past 23 years, the average difference between RBI repo rate and the 10-year government bond yield has consistently been about 1%. Currently, this spread is roughly 0.7%, smaller than the long-term average. If a 0.5% rate cut is made, it may bring the 10-year yield to around 7%.

The bond market usually adjusts before the policy rate easing cycle when expectations are formed, and does so during the first half of the cycle. Near the end of the cycle, the market begins to anticipate its conclusion. Therefore, market movements should be expected next year, especially when inflation aligns with projections or the RBI alters its stance. As yield levels decrease relative to the potential rally, all yield curves, inclusive of various government and corporate bond maturities, are expected to soften. Although dynamic investors tend to react before anticipated market shifts, it's essential to be well-informed. Livemint, the fastest growing news website in the world, can help you keep abreast of the key factors.