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Informist, Wednesday, Aug. 5, 2026

 

By Aaryan Khanna

 

MUMBAI – Bond traders were prepared for the Monetary Policy Committee's rate decision, but the Reserve Bank of India's dovish commentary that put a repo rate hike off the table, even in October, caught them by surprise. The trade-off from this "dovishness" is that some traders fear this guidance could harm the credibility of the central bank's inflation targeting, which could eventually be reflected in bond yields. 

 

The rate-setting panel kept the repo rate at 5.25% and retained its 'neutral' stance, as widely expected. More importantly, it appeared willing to look through above-target inflation in the coming months, taking comfort from the declining inflation trajectory after inflation peaks at 5.9% in the December quarter. Though RBI Governor Sanjay Malhotra highlighted that the committee remained committed to aligning headline inflation to the medium-term target of 4%, the frequent reference to low underlying inflation pressures as measured by core inflation excluding precious metals seemed to suggest the panel was not keen to hike rates, traders said. 

 

In its resolution, the MPC also said more clarity was needed on the composition of inflation and its path before taking any rate action, while stressing there were no signs that price pressures were getting broad-based beyond food and fuel. With uncertainty hovering around the monsoon, the war in West Asia, and global trade policy, bond dealers were of the view that the panel did not appear convinced it would need to combat inflation through rate hikes at its next meeting either.

 

The one-year overnight indexed swap rate ended 11 basis points lower at 5.76% Wednesday, its lowest in nearly a month, as traders reduced the pricing of an October rate hike while retaining expectations of a cumulative 50-basis-point increase over the next 12 months. Those expectations were seen as a hedge against interest rate changes and OIS rates may remain steady while traders accumulate bonds, dealers said. Some market participants felt the panel gave itself the leeway to avoid hiking the repo rate at all in the coming meetings. 

 

"The RBI's decision broadly aligns with market expectations and gives room for yields to fall. The commentary showed that the MPC did not want to hike rates as long as inflation was not broad-based," said Alok Singh, head of treasury at CSB Bank. "I had built in a rate hike in February 2027, but I have taken it out now after the RBI's commentary."

 

The 10-year gilt yield fell to 6.77% Wednesday from 6.82% Tuesday. The five-year benchmark gilt yield – typically more sensitive to the near-term rate trajectory – fell 9 basis points to 6.31%, charting its best day in two months. Short-term bonds were in favour as the RBI governor hinted the central bank would not deploy tools to absorb durable liquidity as part of its monetary management in order to keep the weighted average call rate anchored to the repo rate.

 

The market reaction Wednesday was driven less by the domestic policy outcome and more by Brent crude futures slumping below $80 per barrel on reports the US and Iran were taking steps towards a peace deal to reopen the Strait of Hormuz. With immediate concerns of domestic rate action out of the way, traders said the near-term trajectory of the 10-year yield would largely be determined by global cues within a 6.65-6.85?nd. Malhotra also highlighted the panel would be data-dependent in its next decisions. One risk to the domestic rate pause in October is if the US Federal Open Market Committee hikes the policy rate in September and crude oil prices remain volatile, dealers said. 

 

"For bonds, though, it cuts the other way: with the growth-inflation mix already this favourable, there's very little runway left for an extended rally from here, and yields are likely to stay range-bound, more sensitive to external shocks (West Asia, the Fed's own trajectory) than to anything domestic from this point on," said Sneha Pandey, fund manager-fixed income at Quantum Asset Management Co. "That argues for caution on aggressive duration calls and a greater tilt toward accrual as the more dependable strategy in the near term."

 

Pandey favours short-duration gilts and top-rated corporate bonds maturing in less than three years, as do Franklin Templeton Asset Management (India) and Edelweiss Asset Management Co.  

 

CREDIBILITY QUESTION

The bond market's belief in the messaging was enhanced by headline CPI inflation in the June quarter averaging 30 basis points below the RBI's forecast. These circumstances and this belief could turn very quickly should inflation surprise on the upside. September quarter inflation is projected at 4.7%, rising to 5.9% in Oct-Dec, before easing to 5.5% and 5.3% in the next two quarters. All these readings are well above the RBI's 4% inflation target assigned by the government and a monthly reading could even exceed 6%, the upper end of the target band, if crude oil prices rise further.

 

Neither Malhotra nor the MPC dwelled on headline CPI inflation averaging 5.35% in the 12 months to June 2027, according to the RBI's own forecasts. Nor did policymakers seem worried that retail inflation over the next year would average – or even rise – above the policy repo rate of 5.25%. The negative real interest rate encourages consumption and investment, potentially fuelling inflation as it disincentivises savers. This, along with India's interest rate differential with the US shrinking, is likely to make gilts unappealing to foreign portfolio investors, dealers said. 

 

The prevalent view is that short-term bond yields should fall while less interest-rate-sensitive maturities remain steady, similar to how US Treasury yields reacted to monetary policy in the world's largest economy. While yields on bonds below three years fall as the RBI sweeps away expectations of rate hikes in October and even December, yields on bonds maturing in seven years and higher may harden on the view that the MPC would have to hike rates more sharply later on to bring inflation back down to 4%, dealers said. 

 

To be sure, the government bond yield curve was already expected to steepen with robust demand for bonds from banks to manage their incoming liabilities. The RBI's special scheme on 3-5 year foreign currency non-resident (banks) deposits has already attracted nearly $37 billion of inflows between Jun. 8 and Friday. The total inflows are expected to reach $80 billion-$110 billion by Sept. 30, a mammoth amount that may at least initially be parked in government securities before being used for lending during the upcoming festival season, dealers said. 

 

"If they (MPC) are serious on the 4% target, they have to move on rates," said Rajeev Radhakrishnan, chief investment officer - Fixed Income at SBI Funds Management. "For the near-term, they have given relief and today the flows coming from the FCNR(B) scheme will mask the actual reaction, but over time at least the longer-term bond should reflect concerns that the inflation target is not being upheld."

 

The governor's remark that systemic liquidity would neither be high enough nor persistent enough to push up inflation also rankled some market observers. Instead of focusing on expected price pressure, RBI Governor Malhotra said surplus liquidity would eventually drain through currency in circulation, addressing a slack in demand. The net liquidity absorbed by the RBI – a proxy for the banking system liquidity surplus – rose to INR 3.34 trillion Tuesday, the highest since April. The liquidity surplus may even double in the next two months as FCNR(B) inflows continue and pent-up government spending comes into the system, dealers said. 

 

At the same time, some participants were sanguine that the commentary was best suited for domestic and global conditions in August. A potential end to the war and easing crude oil prices may reduce the build-up of inflationary pressures in the domestic economy. In the interim, the commentary would keep bond yields in check and lead to easier financing conditions in the economy, keeping the growth engine humming despite several external threats of slowdown, dealers said. Moreover, the RBI had given enough signs it would be open to reversing course quickly if circumstances demanded, with Malhotra even saying at the post-policy press conference that the MPC would not hesitate to hike rates if required. 

 

"To me, looking through these supply-side shocks on inflation builds on the RBI's credibility that it is focusing on underlying inflation pressures rather than raising rates due to transitory factors," CSB Bank's Singh said. Further reassuring to traders in this camp was that CPI inflation averaged only 2.1% in FY26, well below the RBI's target, giving some room to look through a transitory spike in prices – even if it lasts a year. 

 

All in all, bond traders had cause to cheer another policy meeting without any signs of monetary policy tightening. They are only uneasy that they are being led down a garden path to be slaughtered when external pressures force the RBI's hand.  End

 

Edited by Saji George Titus

 

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