Inflation surprised to the downside

February's inflation print surprised to the downside, and lower than most economists had anticipated, with headline CPI at 4.4% y-o-y compared to 5.07% in the previous month. Food inflation led the moderation in the headline print which eased to 3.3% in February vs 4.6% in January. Core CPI inflation (ex-food and fuel) remain elevated above 5% reflecting the underlying inflationary pressure in services. WPI inflation also surprised positively as it declined to 2.48% y-o-y in February vs 2.84% in the previous month. We expect CPI inflation to peak around 6% mark by June on adverse base effects and then slide down gradually to sub 4% level towards year end. While the inflation has shown a sharp moderation, Industrial production boosted confidence on the growth recovery as the IIP grew by 7.5% in January. Manufacturing index posted a strong growth at 8.7% y-o-y in the month. 

Bond markets cheered the lower inflation print as yields reversed its rising trend to post a weekly decline of around 11 basis points. Fall in US treasury yield to 2.8% and media reports of government favouring a hike in FPI debt investment limits also boosted the market sentiment. The 10 year benchmark bond closed the week at the yield of 7.56% as against 7.67% in the previous week. We expect US Fed to hike the Fed funds rate by 25 bps in the FOMC meeting on 20-21 March and also indicate a higher rate trajectory in 2018. We see limited scope for yields to fall from here before any clarity on Fed's actions. 

For any directional move, market will closely watch the extent of MSP (Minimum Support Price) increases for the Kharif crops which will be available by May 2018. By that time, we would also get the first estimate of the monsoons, which given the low water reservoir levels, assumes significance for food production and prices. The RBI policy for June 2018 thus becomes a 'Live' one. Until then, the bond market trajectory would he hinged on the movement in Oil prices and Global bond yields. 

Liquidity with commercial banks is now close to neutral which stood at slight deficit of INR 161 billion as of March 16, 2018. Liquidity condition usually tightens in March as tax outflows picks up. Banks also tend to maintain higher cash reserves with RBI which put further pressure on system liquidity. However, this phenomena is temporary and liquidity situation will again ease by early April when government spends its high cash balances. Short term money market rates are likely to fall by early next month as the liquidity pressure eases.

References: QMF

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