Warning signs from India's bond market and why they're miffed

Since the start of the West Asia crisis, 10Y sovereign yields have risen by more than 50 bps across several advanced and emerging markets, including Japan, UK, US, Canada, Italy, Spain and South Korea

India’s bond yields have seen a one-way move in the last twelve months, with the benchmark 10Y g-sec yield rising by almost 90 basis points (bps) since May 2025. None of the headline drivers would have predicted this. 

 

Over the last twelve months, the repo rate and the cash reserve ratio (CRR) saw a cumulative reduction of 75 bps and 100 bps, respectively. This was accompanied by Reserve Bank of India's (RBI’s) infusion of Rs 9.8 trillion in durable liquidity via open market operations (OMO) purchases and forex (FX) Swaps. On the fiscal front, the central government continued to send the right signal by sticking to the path of consolidation despite the provision of substantial tax relief via Income Tax reduction and GST rationalization. 

 

 

What explains the hardening in Indian bond yields then? 

 

First: the gradual deterioration in state finances. The consolidated fiscal deficit of states is estimated to have widened to 3.4 per cent of GDP in fiscal 2025-26 (FY26) from 2.8 per cent in FY23, in contrast to the compression seen in the centre’s fiscal deficit from 6.7 per cent to 4.5 per cent over the corresponding period. While there are several factors behind this divergence, a rising trend towards populism is noticeable in recent years. The cumulative size of unconditional cash transfers undertaken by states has risen from 0.1 per cent of GDP in FY23 to an estimated level of 0.5 per cent in FY26. This has resulted in a burgeoning supply of SDLs (rose from 2.0 per cent of GDP in FY23 to 2.5 per cent in FY26), which ended up competing for loanable funds, thereby putting upward pressure on yields. If the newly elected governments in Tamil Nadu and West Bengal implement their electoral promises, the burden of cash transfers and state borrowings could rise further in FY27.

 

Second: the ongoing regime shift in India’s BoP amid a global environment marked by protectionism and supply chain realignment. The incidence of balance of payments (BoP) deficits has increased amid the ongoing Middle East Crisis. FY27 is expected to mark the third consecutive year of a BoP deficit. Years of BoP deficits tend to bring forth challenges associated with the Impossible Trinity for India. The tussle between monetary policy, exchange rate intervention, and interest rates often obscures the signal for market participants.

 

Three: Even as these two structural undercurrents were at play, a third factor has emerged forcefully in recent months. The weaponization of the Strait of Hormuz by Iran and the US in the ongoing Middle East Crisis and its concomitant impact on energy and fertilizer prices. This has been acutely destabilizing for the global economy. India’s high reliance on the Gulf countries for its energy imports renders its macro-financial balance vulnerable to this disruption. The contagion from BoP to the Rupee is already being felt, with the currency slipping to fresh lows. If the geopolitical conflict does not de-escalate soon, the next round of casualties will be palpable in other key macro variables like inflation, growth, and the fiscal deficit.

 

The global bond market is reflecting this anxiety. Since the start of the West Asia crisis, 10Y sovereign yields have risen by more than 50 bps across several advanced and emerging markets, including Japan, UK, US, Canada, Italy, Spain, South Korea, Thailand, etc. India’s 43 bps rise in bond yields is, therefore, part of a broader global repricing of geopolitical and inflation risk. 

 

The fed funds futures market has now completely priced out the 50 bps Fed rate cut expectation, while a few participants are pricing in the possibility of one rate hike from the Fed in 2027. If realized, this could act as a pivot for the global monetary policy cycle and interest rates. For India, this removes a tailwind the bond market had quietly been pricing in through FY26.

 

For the Indian bond market, the overhang of supply and BoP concerns were already a headwind. The West Asia crisis has begun to worsen them. The likelihood of CPI inflation climbing to the 5-6 per cent range in FY27 from 2.1 per cent in FY26, and a slippage in fiscal targets, could potentially push the 10Y g-sec yield to the 7.25-7.50 per cent range, the highest since the Russia-Ukraine war.

 

One hopes that international diplomacy and behind-the-scenes negotiations diffuse the West Asia tensions sooner rather than later. Hope, however, cannot be a strategy. Acknowledgement of the macro-financial challenges and credible policy guidance can help in anchoring sentiment. Short-term targeted stabilizers (liquidity and regulatory support) should be deployed along with structural measures to stabilize the BoP (fast track bond index inclusion, tax relief for FPI debt investors, special NRI deposits, etc.) and improve fiscal credibility (codification of a rules-based fiscal/debt management policy, etc.). 

 

The global bond market is miffed. Timely policy actions by countries should ensure that it does not turn vigilante.

 

The article is authored by QuantEco Team of Shubhada Rao, Vivek Kumar, and Yuvika Singhal. Views are their own.