Inflation-fisc trade-off is likely to keep bond yields high for now

Financial markets have been under sustained pressure since the onset of the West Asia conflict. A surge in global energy prices has induced a tightening in domestic financial conditions, amid significant volatility in the bond and currency markets.

 

The yield on the benchmark 10-year G-sec has risen by almost 45 basis points (bps) from 6.66 per cent before the onset of the West Asia crisis at end-February 2026 to more than 7.1 per cent currently, the highest level in two years. 

 

Notably, the level of the G-sec yield curve, measured as the average yields of 91-day T-bill, and 3, 5, 10 and 30-year dated securities, has moved up by 28 bps on an average in May 2026 so far from that seen in February 2026, mimicking the impact of a rate hike, even though policy rates have been kept unchanged. This partly nullifies the cooling effect of the 125 bps policy rate cuts that was seen during the previous monetary easing cycle, which had pulled down the level of the yield curve by ~50 bps. 

 

 

The upswing in the yield curve largely reflects worsening expectations around fiscal and inflation outcomes, an unfortunate fallout of the West Asia crisis for India’s macros.  

 

The risks of a fiscal slippage have increased owing to the need for higher fertiliser and fuel subsidies, with the former stemming from higher global fertiliser as well as input prices, and the latter on account of the need to eventually on-budget a part of the sizeable under recoveries by oil marketing companies (OMC) on petrol, diesel and LPG. Besides, lower OMC dividends, excise duty collections owing to duty cuts, and corporate tax collections are expected to constrain the Government of India’s (GoI) revenues. 

 

While the Rs. 1.0 trillion Economic Stabilisation Fund and customs duty hikes on gold and silver imports, are likely to provide some cushion, we now expect the GoI to exceed the budgeted fiscal deficit target for 2026-27 (FY27) of 4.3 per cent of gross domestic product (GDP) by 40 bps, assuming an average crude oil price of $95/barrel in the fiscal. 

 

Besides, inflation projections for FY27 have hardened in the last few months. While the recent hikes in Retail Selling Prices (RSP) of petrol and diesel, and the customs duty hikes on precious metals have reduced fiscal pressure to some extent, this is set to manifest in higher inflation prints immediately. We now expect CPI inflation to average at 4.7 per cent in FY27, with upside risks stemming from any further fuel price hikes, and the impact of the potential El Nino development on agriculture output and food prices.

 

The GoI could reduce fiscal slippage risks by raising fuel and fertiliser prices, although this would worsen inflation outcomes. Alternatively, it could contain inflation pressures, by keeping prices unchanged; this would lead to higher fiscal slippage. Both cases would necessitate higher interest rates, as is reflected in the leveling up of the G-sec yield curve.

 

The INR has lost nearly 6 per cent against the US$ since end-February 2026, making it one of the worst performing emerging market (EM) currencies during this period. This largely reflects the expectations of a material worsening in India’s Balance of Payments (BOP) position and is expected to add to inflationary pressures in the economy. 

 

ICRA expects India’s Current Account Deficit (CAD) to more-than-double to ~2.0 per cent of GDP in FY2027 from the 0.9 per cent estimated for FY2026, amid an enlarging oil import bill. Financing an $80 billion CAD seems like a tall ask, given the compression of net FDI inflows on account of rising repatriation and outward FDI flows. Additionally, the crisis has led to FII outflows, with the sharp depreciation in the USD/INR pair lowering dollar returns. A large drawdown of reserves is on the cards in the current fiscal.

 

The RBI has taken various steps to support the INR. Its net forward sales had increased to a record $103.1 billion at end-March 2026 from $77.7 billion at end-February 2026. Further, it recently announced a USD/INR Buy/Sell swap auction of $5 billion for a tenor of three years.

 

Nevertheless, the pressure in the bond and currency markets appears here to stay, unless the stalemate in West Asia unwinds soon, bringing down energy prices rapidly. 

 

Aditi Nayar is the Chief Economist, Head- Research & Outreach, ICRA. Views are her own.