Indian government bonds edged higher early on Thursday, with the benchmark 6.94% 2036 bond yield down 2.5 basis points at 7.3714% at 11:40 a.m., after falling as much as 4 basis points at the open. According to The Economic Times, the recovery tracked a rally in US Treasuries, but gains were capped by concerns over tighter liquidity, higher interest rates and mounting supply pressures. Traders are curbing risk levels prior to a major debt auction and the Reserve Bank of India's tighter cash-reserve-ratio maintenance requirements that take effect on Friday. The one-year OIS rate rose 1.5 basis points to 6.4450%, the two-year rate dropped 1.5 basis points to 6.58%, and five-year rate eased 3.25 basis points to 6.7675%, as reported by The Economic Times. Sherilyn Chew, multi-asset strategist at DBS Bank, noted that "the near-term direction of IGB yields remains skewed higher as the RBI continues to tackle inflation risks, excess liquidity and currency stability concerns."
India's ultra-short-term borrowing costs surged at Wednesday's treasury bill auction, with 182-day and 364-day treasury bills sold at cutoff yields of 6.29% and 6.49% respectively, marking their highest levels in approximately 18 months. According to reports from The Hindu BusinessLine, yields for both maturities rose more than 20 basis points compared to a week ago, reflecting increased investor concerns about monetary policy tightening. The latest auction results come as rupee swap markets are currently pricing in nearly 100 basis points of rate hikes over the next 12 months, indicating strong market expectations for continued monetary tightening. This week's auction is limited to the 10-year bond, which also weighed on the market, with short positions being built in that segment, as noted by The Financial Express.
The premium over the 5.5% RBI repo rate jumped to 79 basis points for six-month notes and 99 basis points for one-year notes, levels last seen in November 2022. As reported by The Hindu BusinessLine, this represents a four-year high for the spread over the benchmark policy rate. The Reserve Bank of India hiked rates for the first time in nearly four years last week and shifted its stance, signalling more increases ahead. The central bank's hawkish commentary and regulatory measures have reinforced market expectations for an aggressive rate hike cycle, with RATES reporting that RBI's measures and mounting inflation risks have both increased wagers of a December rate hike. The yield on the five-year bond rose five basis points to 7.13% on Wednesday, with markets now expecting a 50-basis-point rate increase at the December policy review, according to The Financial Express. Some investors see the policy rate climbing to as high as 6.5%, from 5.5% now, if oil prices stay elevated, said VRC Reddy, head of treasury at Karur Vysya Bank, as reported by NDTV Profit.
India's wholesale inflation accelerated at an unexpected 11.39% in September, leading to growing concerns over potential future monetary policy shifts. According to The Economic Times, India's September consumer inflation accelerated to 5.54%, and a majority of economists expect it to breach the RBI's 6% tolerance ceiling in October. On the day, oil prices rose 0.8% to $106 a barrel, adding to the pressure on inflation. The RBI, which targets retail inflation, raised the repo rate last week for the first time in nearly four years. Payal V. Pandya from Bajaj Broking Prive noted that "with CPI inflation already closer to the RBI's upper limit of tolerance, if that is breached in upcoming data, a rate hike in December 2026 MPC meeting would be inevitable."
The Indian rupee continued to gain strength, rising as much as to 94.75 against the dollar before settling at 95.16 on Wednesday, up 13 paise from the previous close, according to The Financial Express. It strengthened 1.6% over the past three sessions after a sharp recovery from 96.73, near its record low. The rupee's recovery has been supported by the RBI's recent forex measures, with the rupee's year-to-date depreciation in 2026 narrowing to 5.9% from 7% earlier. RBI Governor Sanjay Malhotra's comment that the central bank could announce further measures, if needed, to contain volatility added to the positive sentiment. However, Malhotra's comment that the RBI does not normally use monetary policy to address financial-stability risks, though the two cannot be separated, has reinforced market expectations for continued monetary tightening. For now, the RBI's measures have helped the rupee rally 1.6% this week to around 95 per dollar, but the question remains how long that relief can last, as Brent crude remains above $100 a barrel amid turmoil in the Middle East, inflation has climbed to a two-year high and surging US yields are pulling capital away from emerging markets.
While expected rate hikes are largely priced in, tighter cash conditions may be the bigger surprise for the bond market. Defending the rupee means selling dollars, and every dollar the RBI sells pulls rupees out of the financial system, leaving banks with less cash to lend to each other and less to invest in government debt. That liquidity squeeze may be the bigger surprise for the market, according to Gaura Sen Gupta, chief economist at IDFC First Bank. "So far, liquidity was the wall that had protected domestic bonds from the global selloff, but now that cover is reducing," she said. She sees the 10-year yield trading between 7.20% and 7.50% in the near term, compared with an earlier forecast of around 7.25%. Puneet Pal, head of fixed income at PGIM India Mutual Fund, expects the 10-year yield to climb to as high as 7.60% over the next month, as reported by NDTV Profit. The RBI has already encouraged banks to raise $133 billion from Indians overseas in less than three months, a drive that ended in August but failed to reverse bearish sentiment, leaving the central bank with increasingly difficult choices.
