Thursday, September 16, 2010

Why did RBI raise the repo and reverse repo rates today?

The RBI has been quite proactive about controlling inflation. For the 5th time since Mar ‘10, interest rates have been raised – the repo rate by 25 basis points (from 5.75% to 6%) and the reverse repo rate by 50 basis points (from 4.5% to 5%).

Inflation has been the dominant concern in economic management for the RBI, and raising interest rates is one way of addressing that concern. There are signs that RBI’s policies are beginning to have some effect – although housewives will surely disagree, as food inflation still remains high.

Market players had ‘factored in’ a hike of 25 basis points in both the repo and reverse repo rates. That means, the rate hike was expected. If there was a surprise, it was the 50 basis point hike in the reverse repo rate – double the expectation.

Was today’s drop in the Sensex a reaction to the rate hike? May be. May be not. After seven days of sharp rise following the break above a year-long trading range, a bout of profit booking is only to be expected. It is healthy for the sustenance of the bull market.

Is the repo rate and reverse repo rate increases good news or bad news for investors?  A bit of both. The good news is that the banks will probably increase their fixed deposit rates. Some have already done so, under the guise of ‘Festive Season Bonanza’, or higher rates for specific periods of 790 or 990 days, or special rates for senior citizens.

The bad news is for those who are paying Equated Monthly Installments (EMIs) on home loans or auto loans or personal loans. Their monthly EMIs will increase.

What should investors do? This may be a good opportunity to book part profits in stocks that have run up a lot and move the cash into a bank fixed deposit. That may sound unexciting to young investors, who prefer to flit around from one stock to another. But that is a sure way to lose the booked profits.

If you do take your profits away from the stock market and invest in a bank fixed deposit, make sure you opt for quarterly dividends. Use a part of the quarterly dividend amount to buy Nifty BeES or Bank BeES or an index fund. That way, you reinvest in the market but do not put your booked profits to any risk.

Related Posts

The RBI has increased the Repo and Reverse Repo rates – should investors be concerned?


Pinals said...

Hi Dada,

Can you elaborate this statement : "invest in a bank fixed deposit, make sure you opt for quarterly dividends."

To my knowledge Bank FD gives Interest & never gives Dividend & that is too taxable interest as per current I.T. norms.

May be you want to refer Bank FD to/and/or similar product in MF, which of course has Dividend option which is not fixed in nature ( In % terms and frequency) & can be distributed at sole direction of Fund Manager subject to availability of surplus distributable profit, which is also taxed & deducted by MF industry before distributing to their unit holders as per the scheme..

Please let me know do I have wrongly understood the statement or I have missed something..!!??

Subhankar said...

Thanks for pointing out my mistake! I meant 'quarterly interest' for bank fixed deposit and 'dividend option' for funds (where available).

Getting sloppy with age!

Sanjeev Bhatia said...

Hi Subhankar Da,

Nice post as usual. Would like to point out that the situation is more ripe for profit booking, at least partial. As on wednesday, we are at a Nifty PE of 24.72 which is too high for comfort. Historical evidence shows that Nifty has never hovered above 23.5 for long. I suggest complete bail out from stocks which have reached too high valuations, dud stocks/mutual funds which you unfortunately accumulated etc. Another pointer is that on both tuesday and wednesday, Nifty shot up like anything but on both these days the market breadth was negative. In fact on tuesday, there were 2 shares falling for 1 share rising despite nifty shooting above 5860.

You have mentioned Nifty BEES etc. My experience with Nifty BEES has, however, not been very encouraging. I had taken small position in Niftybees as I was getting interested in Indiex funds due to passive management, lower expenses and market return atleast equal to Indices. My investment in NiftyBEES in May 2009 has just yielded 18-19% returns till date while equity mutual funds have returned fab returns during this period. My suggestion is, go for good diverisified mutual funds rather than ETFs. Historical evidence also suggests in favour of diverisifed MFs rather than Nifty BEES with too much outperformance from MFs.

Hope this helps.

Sanjeev Bhatia CFP

Sanjeev Bhatia said...

Just to put things in perspective here is an interesting data:-

1. In the trading range from 2 april 2001 to 12 march 2010, Nifty has traded for ONLY 97 days out of total of 2228 trading days, that is just 0.0435%, at PE of more than 23.

2. Nifty has traded for ONLY 61 days in these 2228 days at PE of more than 24.6. That is miniscule 0.0273& of this trading range.



Subhankar said...

Appreciate your comments, Sanjeev.

The Nifty P/E data is quite compelling, so you might want to book out completely. But there are good technical reasons why you shouldn't. I'll try to explain in my Sensex analysis this Saturday (Sep 18 '10).

If you combine partial profit booking with trailing stop-losses, then you may catch some big moves. It really depends on your risk tolerance levels.

The reason for suggesting Nifty BeES was to protect the downside. Many diversified MFs fell 80-90% during the last bear market - though the Sensex dropped only 60%.

Jasi said...

Hello Sir and Sajeev,

Fab job both of you :)

@Sanjeev, investing in ETF or index funds is more like insurance. As sir has said, they are more to protect the downside. Of course in times like these when markets are on steroids, ETF/index funds do lag some of the funds. You wud notice when the markets tank, ETF/index funds may not fall as much as some of diversified funds may.

@Sir, very decent analysis.
Altho i gotta admit more than once during this week I was expecting your post on the abnormal sensex movement ;)

Keep the good work up! :)