India’s bond market approaches next week’s Monetary Policy Committee meeting with cheap overnight funding offering little comfort to traders whose carry positions have been hurt by mark-to-market losses. The disconnect between overnight rates and bond yields has made the next repo decision only part of the market’s problem, because investors must also assess the length of the tightening cycle, liquidity management and the supply of bonds.

With the one-year Treasury bill trading around 6.12% and the two-year government bond around 6.54%, the curve is exceptionally steep relative to overnight rates, even though banks remain flush with liquidity. Bank funding costs underline that disconnect, with three-month certificates of deposit at 6.35% and one-year certificates at 7.60%, while the weighted average call rate remains significantly below the repo rate.

For investors entering the policy meeting, the question is not simply whether the RBI begins raising rates in October, but whether the eventual cycle validates the tightening reflected in market prices and how any accompanying liquidity action affects the yield outlook.

Rate Expectations
Overnight indexed swaps are pricing in around 115 basis points of rate increases over a year, whereas most economists expect a much shallower cycle of 50–75 basis points, ending at a repo rate of 5.75–6.00%. That gap makes the likely peak in the policy rate at least as important to the market assessment as the immediate decision.

The steepness of the curve does not, by itself, settle which view will prevail, as comparable conditions in 2018 and 2022 preceded markedly different outcomes. While 2018 brought a modest 50-basis-point rate cycle, the tightening that began in 2022 eventually amounted to 250 basis points.

The base case here is a 50-basis-point cycle beginning in October and ending at a repo rate of 5.75%, under which the curve would be expected to steepen in the 2–10-year and 5–10-year segments. The five-year government bond–OIS spread, currently around 20 basis points, could narrow towards zero under that scenario.

A 75-basis-point cycle taking the repo rate to 6% by February would imply a different adjustment, with short-end yields retaining room to rise another 10–15 basis points. Under that outcome, the five-year bond–OIS spread could widen towards 30 basis points rather than compress.

The inflation outlook keeps the second scenario in contention, with September CPI inflation expected to be around 5.8% and readings projected to remain above 5% for eight to nine months from September. Alongside policymakers’ optimism about 7% growth becoming the new normal, that trajectory leaves the market with reason to consider a 75-basis-point cycle rather than treat the shallower outcome as assured.

Beyond Rates
Even a clear view of the rate cycle would leave investors facing uncertainty about liquidity management, because banks remain flush with funds and the weighted average call rate is significantly below the repo rate. A rate increase in these conditions could exert less restraint than its announced size suggests, creating the possibility that it is accompanied by a further ₹1 trillion of open market bond sales.

For bondholders, the relevant policy outcome would therefore be the combination of the repo decision and any accompanying liquidity operation, rather than the rate announcement alone. The carry losses already incurred also underline why inexpensive overnight funding cannot be treated as protection against adverse movements in bond yields.

The rupee’s return to nearly 96 to the dollar adds another complication, coming amid renewed foreign portfolio outflows after two months of equity inflows in July and August. September has seen withdrawals of around ₹260 billion from equities and nearly ₹200 billion from bonds, while a decision to hold rates in October could leave the currency vulnerable to revisiting its May low of around 96.80.

Rising one-year forward premia and MIFOR rates could transmit some of that pressure into domestic borrowing conditions, with three- to five-year MIFOR rates close to 8% making external commercial borrowing potentially less attractive. A shift towards rupee borrowing would add to local funding demand and could exert further upward pressure on bond yields.

Longer-dated bonds also face pressures that a shallow rate cycle would not necessarily offset, including the Eighth Pay Commission outcome, the usual pressure from state government bond issuance in the third and fourth quarters of 2026–27, and higher monthly net central government bond supply. These pressures could bear particularly on the 10–15-year segment.

Indian government bonds have so far outperformed emerging-market peers and US Treasuries, but that relative resilience could diminish as domestic supply pressures meet a global backdrop of higher-for-longer yields. The long end therefore has risks of its own, even under a policy outcome that limits the eventual increase in the repo rate.

A temporary easing of the Middle East conflict before the meeting could change the immediate backdrop without resolving these questions about the rate cycle, liquidity and supply. For bond investors, any relief would still need to be assessed against the underlying pressures on different parts of the curve.

The market consequently enters the MPC with a steep curve, sharply different expectations for the tightening cycle and little comfort from carry after significant mark-to-market losses. A shallow cycle would still leave longer maturities exposed to borrowing pressures, while a higher terminal rate could push short-end yields further up, making the policy path and its implementation more consequential than the first repo move alone.