The Federal Reserve has lowered interest rates for the first time in four years. On September 18, the United States central bank announced a 50-basis-point cut in its primary lending rate. Although a decrease in rates was widely expected, the magnitude of the reduction surprised some. This action by one of the world's most influential central banks is expected to have significant effects globally, impacting monetary policies, financial markets, and consumer mortgages and savings rates worldwide.
The Federal Reserve's move will also influence the Reserve Bank of India's monetary policy. The Monetary Policy Committee (MPC) increased the repo rate by 2.5 percent from April 2022 to May 2023. Over the past year, the RBI has maintained the repo rate at a standstill, signaling a low likelihood of an increase in interest rates. Additionally, the central bank's monthly bulletin suggests that India's headline inflation could average 4.5 percent in the latter half of the fiscal year, driven by lower crude oil prices.
Taking these factors into account, it's probable that the Reserve Bank of India will initiate a cycle of interest rate cuts starting early 2025. The key question now is how to capitalize on this situation. There are various strategies available, but investing in long-duration debt funds appears to be the most promising due to its favorable risk:reward ratio.
During the previous cycle of rate cuts from August 2018 to May 2020, the Reserve Bank of India reduced the repo rate by 2.5 percent. During this time, long-duration debt funds saw decent returns. There's a direct relationship between the price and yield of a bond. According to Sebi's categorization, there are 16 types of debt mutual funds. As bond yields decrease, bond prices increase, benefiting long-term bond funds the most. Should interest rates fall by 2 to 3 percent over the next 3 to 5 years, it's expected that long-duration debt funds will outperform other debt funds.
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