RBI talking tough but may not follow hawkish policy yet

Call on rates depends on whether the RBI believes the trend of lower inflation will continue

The RBI policy review, due this week, has everyone guessing. While inflation has moderated in year-on-year (y-o-y) terms, it is still very high. At the same time, the Index of Industrial Production (IIP) indicates that growth remains weak. High inflation and high inflation expectations might induce the RBI to keep rates at current levels or raise them. But low IIP growth and a trend of falling inflation could induce the RBI to cut rates.

The central bank says it prefers to target retail inflation, which is tracked via the consumer price index (CPI). The overall CPI (combined rural and urban) is running at around 9.9 per cent, y-o-y in December. The "core" CPI, stripped of fuel and food items, is running at just above 8 per cent.
 
The overall CPI has dropped from above 11 per cent in November. However, the core CPI has actually risen marginally from just below 8 per cent. At the same time, the wholesale price index (WPI) has also moderated slightly, to about 6.2 per cent y-o-y in December from 7.5 per cent in November. Core WPI is low.

What is the RBI likely to do in the circumstances? The market has slid on the basis of a remark by the governor who has said inflation is a "destructive disease". However, this doesn't necessarily mean that the RBI intends to raise rates. The governor may be talking tough without intending to follow through with hawkish monetary policy.

Raghuram Rajan talked tough and held rates unchanged in December despite higher November inflation. He gambled at that time on food inflation rates dropping and overall inflation coming down as a result.

Will he hold rates now since inflation has indeed come down, due to easing vegetable prices? This depends on whether the RBI believes the trend of lower inflation will continue. Central bank policy is driven more by future expectations than last month's data. There is strong consensus that inflation is unlikely to fall much over the course of the next several months and this could influence the RBI.

Most traders and investment houses will try to second-guess the RBI, of course. But the consensus could be wrong or opinion may be almost evenly divided. A case could be made for any course of action; so, traders and investors could be direction-neutral in aggregate.

If a trader has no directional bias, one way to play the situation is to strangle the Bank Nifty. A long January Bank Nifty call and a long BN January put may at some distance from money not cost very much in comparative terms. But January expires within two sessions of the policy. February options will cost more and they are not that liquid.

A third strategy is to simply get out of rate-sensitives and wait for the policy. If the RBI hikes, go short. If the RBI cuts, go long. Toss a coin, or go short, if the RBI does nothing. I'd be more inclined to short on inaction because the background indicators don't look good and sentiment seems to be weak globally.

A fourth strategy is the most risky. Pick a direction and take a futures position in the BN prior to the policy. If the trend moves in the direction of the position, bumper profits might result. If the trend breaks in the opposite direction, reverse the position. That is, exit the prior position and take one in the opposite direction. If the post-announcement trend is strong, you may still make some profit.

A fifth strategy is possible. Going by previous history, there will be massive volatility in rate-sensitives across the policy session. Since financials have a high weight in the Nifty, this could result in a wide high-low range for the major index. It might make sense strangling the Nifty rather than focussing on the Bank Nifty. Purely on the basis of liquidity, positions in the February Nifty option series could be more comfortable.