As the Monetary Policy Committee (MPC) decided to defy all expectations to hold its repo rates at 5.15 per cent yesterday, a sigh of relief must have gone around retirees and fixed deposit investors. But as the MPC has kept the door open for further cuts by signalling an ‘accommodative stance’, they must be wondering – “Is this rock-bottom for interest rates? How much lower can they go?”

While this will depend on whether a further monetary booster is needed to shake the economy out of its slumber, it is useful to remember that declines in interest rates, like dips in the stock market, do not last forever. The history of previous rate cycles in India is useful to gauge how low rates can go and how long such phases last.

Previous downcycles

The 20-year history of repo rates in India from 1999 till date throws up four distinct periods when rates fell steeply. The first such phase was from April 2001 to March 2004 when a sluggish economy prompted RBI to slash its repo rate from 9 per cent to 6 per cent. A second sharp fall in rates materialised in 2008-09, after the global financial crisis, when RBI reduced the repo from 9 per cent in July 2008 to 4.75 per cent by April 2009. A third and much shallower downcycle occurred in 2012-13, when RBI took down rates from 8.5 per cent in October 2011 to 7.25 per cent in May 2013, before reversing this. The latest downcycle which began in 2014 has seen the repo rate tumble from 8 per cent in January 2014 to 5.15 per cent now.

Tops and bottoms

These previous episodes tell us three things about rate cycles in India. One, it is extremely rare for the repo rate to go below the 5 per cent mark. So far, it has happened only once, in April 2009. This suggests that even if the MPC unleashes further cuts in future, the repo may not dip below 4.75 per cent.  

Two, when rates fall below 6 per cent, they usually rebound within a year. In 2008-09, the repo rate stayed below 6 per cent for all of nine months and was back at 8.5 percent by October 2011. In 2004, it stayed at 6 per cent for seven months before the next upcycle began. But it took four years until 2008 for it to hit 9 per cent again. In the current cycle, repo rates fell below 6 per cent in June 2019 and have spent 6 months below that level. Past data trends suggest that they may not stay at these levels for long. However, a revival does not mean that rates can climb up sharply to 8 per cent any time soon.

Three, rate cycles in India have typically bottomed out close to 5 per cent and topped out at 8-9 per cent. But MPC’s inflation targeting framework since 2015 changes these dynamics. Since 2015, the MPC has been bound by an agreement with the Government to keep India’s CPI inflation in a band of 2 to 6 per cent. In practise, while the MPC hasn’t minded inflation falling to the 2 per cent mark, it has gotten nervous whenever it has topped 4 per cent.

RBI also works on a thumb rule to ensure that savers always get ‘real’ interest rates of 1.5 to 2 per cent above the prevailing inflation rate.

Right now, India’s GDP growth is dismal (4.5 per cent in the latest quarter), but the CPI inflation rate has crept up steadily from under 2 per cent in January 2019 to 4.62 per cent in October 2019. This is what seems to have prompted MPC to put off a rate hike now, for a wait-and-watch approach. RBI also works on a thumb rule to ensure that savers always get ‘real’ interest rates of 1.5 to 2 per cent above the prevailing inflation rate. With inflation already at 4.62 per cent, this also reduces room for rate cuts.

What about the other rates

But as fixed income investors, it is important for you to know that interest rates on deposits and bonds do not necessarily follow in the MPC’s footsteps.  

In the last one year, as the repo rate tumbled by 1.35 percentage points, median deposit rates of banks fell only 0.47 percentage points. With RBI pressuring banks on transmission, a further cut in deposit rates, albeit marginally, cannot be ruled out. SBI currently offers 6.25 per cent for term deposits of 1-5 years.

But while leading banks may have no problem attracting deposits even if they cut rates, smaller private sector banks and small finance banks will have trouble attracting depositors if they prune rates. They may hold on to their present rates.

As to the bond markets, they have a habit of always being two steps ahead of the MPC. After tumbling to 6.2-6.3 percent mark way back in June, the 10-year government bond yield has since risen up to 6.6 per cent now.  With inflation rearing its head and the Government likely to overshoot deficit targets, the market yields may have already bottomed out. 

So what should fixed income investors do today?

• If you’re holding emergency money in leading banks, be aware that the rates are close to bottom. Avoid locking in for over 1 year.
• Post office schemes are currently an island of high rates offering 6.9-7.9 per cent. Given that they’re sovereign guaranteed, lock into them while the going’s good.

If you find non-government debt instruments that are still offering 8.5-9 percent, be aware that they’re probably quite risky to be paying you 2-2.5 per cent over market rates. Don’t risk your capital for that extra return, especially as the rate cycle can turn.