Bond Market Mood Turns as Inflation Reset Cools Yields

The Indian bond market is not turning bullish; it is merely recalibrating. 

After a year in which nearly ₹13 trillion of durable liquidity infusion failed to produce meaningful monetary transmission, government bond yields are finally encountering temporary relief. The 10-year government bond, which tested 6.75%–6.77%, now appears likely to stabilise in a 6.55%–6.77% band at least until June, when clarity emerges on the monsoon and on potential inclusion in Bloomberg’s Global Aggregate Index.

This is not the end of the bear market. Rather, it is a pause shaped by arithmetic, softer inflation optics and a marginal improvement in supply signalling.

The first shift in tone came from supply management.

The February 12 switch between the Government of India and the Reserve Bank of India, worth about ₹700 billion, lowered projected gross borrowing for 2026-27 to roughly ₹16.5 trillion from ₹17.2 trillion. The numerical reduction was modest, yet the signalling effect mattered. Had the switch been announced alongside the Union Budget on February 1, the 10-year yield might not have retested 6.77% after closing near 6.70% on the Friday prior to Budget day. Markets can digest large issuance if the contours are clear; what unsettles them is uncertainty.

Stability in the rupee’s exchange rate after the US trade understanding also helped cool bearish positioning in five-year overnight indexed swaps and government bonds, 

While foreign equity inflows of about $2 billion in February to date provided limited but visible support, structural imbalances remain.

Public sector banks, historically the largest buyers of sovereign paper, have largely stayed on the sidelines, with incremental statutory liquidity ratio investments rising barely 3% in 2025-26.

The incremental credit-to-deposit ratio hovers near 82%, underscoring deposit scarcity amid firm credit demand. Even if core liquidity rises to ₹4.5 trillion by March-end, the next financial year may still require ₹3 trillion–₹4 trillion of open market operations to sustain reserve money growth.

Since early February, the central bank has also refrained from conducting variable rate reverse repo operations, allowing surplus liquidity to seep into the short end of the curve and providing support to bond yields. With March likely to see sizable advance tax and goods and services tax outflows, variable rate reverse repos may remain absent through February and March, preventing premature liquidity tightening.

The relief rally, therefore, is tactical rather than structural.

Inflation Optics
The more decisive shift in sentiment came from inflation. 

January’s consumer price index under the new 2024 base year printed 2.75%, while core inflation was closer to 3.4%, materially below market expectations of 4.5%–5%.

Bond markets had braced for higher readings because weights for housing, transport and communication were increased. Instead, the reweighting softened the overall picture.

The weight of food and beverages declined to 36.8% from 45.9%, fuel and light fell to 5.4%, and gold’s share was reduced sharply.

Core, defined as headline excluding food, fuel and tobacco, now constitutes roughly 54.9% of the basket, up from 48.2% earlier.

Precious metals distortions eased as jewellery weights declined and the index moved from directly incorporating gold and silver prices to reflecting jewellery pricing instead.

Personal care inflation moderated to 19% year on year compared with 28% under the old base, while core excluding precious metals, stood near 2%. Housing inflation, already subdued, softened further to around 2%.

The implication is significant. Headline CPI in 2026-27 may prove closer to 4% rather than the earlier expectation of 4.4%–4.5%.

Imported disinflation from China, stability in the rupee’s exchange rate and prospective customs duty reductions following recent trade deals reduce the likelihood of a meaningful resurgence in core inflation.

Such conditions support an extended policy hold through calendar 2026 and possibly till March 2027, anchoring long-term inflation expectations and compressing term premia at the long end of the curve.

The subdued core inflation also signals weak aggregate demand.

A low current account deficit suggests a negative output gap, and if artificial intelligence materially constrains hiring by large information technology exporters, consumption momentum could soften again after the temporary boost from goods and services tax adjustments, prompting the RBI to stay focused on growth.

Prints under the new GDP series will require careful interpretation, as base effects can flatter the headline while underlying demand remains fragile.

Supply Push
External conditions have turned incrementally supportive, with long-end yields in the US and Japan retreating from recent highs and easing pressure on emerging market duration. Crude oil trading near $68–$70 per barrel embeds an estimated $5–$8 geopolitical premium that could unwind if tensions ease and additional supply reaches markets.

The underlying constraint, however, remains supply.

Combined gross issuance of central and state debt next year may approach ₹29.4 trillion, with state development loan supply remaining elevated as states continue expansive welfare spending, and without institutional reform the burden will increasingly fall on the central bank’s balance sheet.

Either the Reserve Bank of India will have to start warehousing state papers (SDL OMOs), or the government may need to explore a unified borrowing framework that effectively converts state supply into quasi-sovereign issuance more acceptable to foreign portfolio investors.

This reform remains to be seen.

Absent clarity on such reforms, heavy sovereign borrowing risks crowding out private issuance, a dynamic already visible in softer corporate bond supply as funding costs remain elevated across the sovereign, corporate and money market curves.

High borrowing rates themselves risk deepening the negative output gap. If liquidity turns abundant after the central bank’s dividend transfer to the government in May, tools such as Operation Twist may prove more appropriate than variable rate reverse repos in shaping the curve.

For now, the wind has shifted.

Inflation optics are softer, supply arithmetic has marginally improved, and global yields have steadied. The bear grip on Indian bond yields has loosened, but it has not yet let go.