Whalesbook
The Lede
The Indian bond market presented a stark paradox in 2025, bifurcating into two distinct halves. The year commenced with significant optimism, marked by a robust rally in the 10-year government security (G-Sec), pushing yields down substantially. This initial surge was underpinned by expectations of monetary easing, prudent fiscal management, and favorable market conditions.
However, this positive momentum dramatically reversed in the latter half of the year. Despite continued policy rate cuts by the Reserve Bank of India (RBI), bond yields began to climb, and the yield curve experienced a bear-steepening trend. This divergence between monetary policy and bond market performance signaled deeper underlying concerns.
First Half Rally
From January 1, 2025, the 10-year G-Sec yield dropped from 6.78 percent to a low of 6.18 percent by June 5, closing June at 6.30 percent. This approximately 50 basis-point decline was propelled by an aggressive 100 basis-point rate cut by the RBI's Monetary Policy Committee (MPC) by mid-year. Investors also reacted positively to sustained fiscal discipline and balanced demand-supply dynamics in the debt market.
The period was also characterized by a stable rupee and a steady increase in foreign exchange reserves, which peaked by the end of June, creating a generally supportive macroeconomic environment for bonds.
Second Half Reversal
The narrative shifted dramatically after June. The 10-year G-Sec yield climbed to 6.56 percent by December 26, 2025. This happened even as the RBI continued its easing cycle, including a 25 basis-point cut in December, highlighting a breakdown in monetary policy transmission. The rally faltered, replaced by a bear-steepening of the yield curve, where longer-term yields rose more sharply than shorter-term ones.
The catalyst for this reversal was an adverse external shock, initially perceived as temporary, which evolved into a persistent drag on India's external sector. This impacted the currency and worsened the trade balance.
Currency and External Pressures
Since July 1, the Indian rupee has depreciated by approximately 4 percent, becoming one of the weakest currencies among emerging markets. Foreign exchange reserves saw a decline in the second half as the RBI shifted its intervention strategy. Concurrently, government bond yields hardened by 25-30 basis points despite the December rate cut.
Yield Curve Dislocation
India's current easing cycle has been rapid, with 125 basis points of cuts in just ten months, and potential for another cut in February 2026. However, bond markets remain skeptical. The 10-year yield has risen about 30 basis points since June, indicating poor policy transmission. The yield curve has steepened, not in a positive way (bull steepening), but through bear steepening, as long-end yields increased.
Spreads have widened significantly. The 10-year G-sec now yields around 130 basis points above the policy repo rate, and the 10-year to 3-year spread is considerably higher than its long-term average.
Macroeconomic Strength vs. Bond Bearishness
The core macroeconomic indicators present a 'Goldilocks' scenario, seemingly at odds with bond market pessimism. Inflation stood at a mere 0.7 percent year-on-year in November 2025, with FY26 inflation projected around 2 percent. Real GDP growth remained robust at 8 percent in the first half of FY26. These conditions typically favor bond rallies.
Fiscal fundamentals have also improved, with the fiscal deficit narrowing to 4.8 percent of GDP in FY25 from 9.2 percent in FY21, adhering to the fiscal glide path. Despite this favorable backdrop, bond yields are ignoring rate cuts, prompting questions about the market's concerns.
Fiscal Worries and Debt Levels
While structural fiscal health has improved, concerns about the debt trajectory, particularly at the state level, are re-emerging. The focus has shifted from reducing the fiscal deficit to lowering the debt-to-GDP ratio post-FY25, but a clear roadmap is missing. The government aims for a 50±1 percent debt-to-GDP target by FY31, but the lack of a glide path creates uncertainty. Weaker state finances add another layer of risk.
Supply-Demand Imbalance
The issuance of long-dated government securities (G-Secs) and state development loans (SDLs) poses another challenge. While the central government has managed its issuance, state fiscal pressures are expected to keep overall bond supply elevated. Simultaneously, demand from traditional long-term investors like banks, insurance companies, and pension funds is waning due to regulatory changes and slower asset growth. This supply-demand imbalance is a key reason for elevated yields.
The Weakening Rupee
Persistent pressure on the rupee, attributed to delays in the India-US trade deal, subdued capital inflows, and a widening trade deficit, is significantly impacting market sentiment. Concerns about capital outflows and import-led inflation add to bond market volatility. This puts the RBI in a difficult position, facing a trilemma: easing rates for growth, defending the currency, and avoiding further bond market stress.
The Way Forward
Monetary policy easing appears largely complete, with room for perhaps one final 25 basis-point cut in February or April 2026, given the projected inflation around 4 percent in H1 FY27 and a real rate of 1.25 percent. However, the RBI might pause to preserve policy space, especially if growth falters due to higher tariffs or if rupee pressure persists.
Preserving monetary firepower is crucial as fiscal space is limited. The government has already implemented significant fiscal stimulus. This increases the likelihood that the RBI will maintain flexibility in its rate decisions, dependent on global headwinds and domestic growth.
Inflation is expected to remain contained due to structural factors, allowing policy rates to stay lower for longer. Monitoring the introduction of the new CPI series (2023-24 base) will be important.
The overall macroeconomic environment supports stable, lower policy rates, with risks primarily from the external sector. Bond yields are expected to remain range-bound with a downward bias. Key hopes for improvement include a US trade deal, fiscal prudence in the Union Budget, and the inclusion of Indian bonds in the Bloomberg Global Aggregate Index in Q1 2026, which could bring substantial foreign portfolio investor inflows.
Impact
This bond market dislocation could lead to higher borrowing costs for the government and corporations, potentially dampening investment and economic growth. A persistently weak rupee could fuel inflation, affecting consumer purchasing power and corporate input costs. Investor sentiment towards Indian debt may weaken, impacting capital inflows. Conversely, if the situation resolves, it could spur investment and stabilize the currency. Impact rating: 7/10.
Difficult Terms Explained
- Basis Point (bp): A unit of measure equal to one-hundredth of one percent (0.01%). Used for bond yields and interest rates.
- Yield Curve: A graphical representation of the yields on bonds of varying maturities. It typically slopes upward, showing higher yields for longer maturities.
- Bear Steepening: A phenomenon where the yield curve becomes steeper, with long-term yields rising faster than short-term yields, indicating market expectations of higher future inflation or growth, or concerns about government debt.
- Trilemma: In economics, a situation where a central bank faces three desirable but incompatible policy objectives: maintaining a fixed exchange rate, free capital movement, and an independent monetary policy. The RBI faces a trade-off between growth, currency stability, and bond market stability.
- Fiscal Glide Path: A medium-term plan outlining the government's strategy for reducing its fiscal deficit and debt levels over time.
- Fiscal Deficit: The difference between the government's total expenditure and its total revenue (excluding borrowings).
- GDP (Gross Domestic Product): The total monetary value of all finished goods and services produced within a country's borders in a specific time period.
- G-Sec (Government Security): A debt instrument issued by the central government to borrow money.
- SDL (State Development Loan): Debt instruments issued by state governments to finance their spending.
- FPI (Foreign Portfolio Investor): An investor who invests in the securities of a country from outside the country.
- MPC (Monetary Policy Committee): A committee that uses monetary policy tools to manage inflation and stimulate economic growth.