RBI and the Bond Market Are Living in Parallel Worlds

The Reserve Bank of India’s February policy decision once again highlighted a growing disconnect between monetary policy outcomes and bond market behaviour. The Monetary Policy Committee was comfortable with its stance, citing stable growth, benign inflation dynamics, and improving liquidity conditions since December. Bond markets responded by pushing yields higher, reinforcing the sense that near-term supply-demand forces now dominate price discovery at the long end.

This divergence raises a more basic question.

Is it time to delink the interpretation of monetary policy outcomes from near-term bond market trends?

Government bond yields are currently being driven less by the policy rate or the stance, and more by factors largely outside the MPC’s immediate control. Auction supply, gross borrowing optics, balance sheet constraints among banks and dealers, year-end liquidity effects, and episodic foreign exchange intervention have combined to create a market microstructure in which technicals overwhelm macro signals. 

In such an environment, yields are unlikely to transmit policy intent smoothly. Instead, they develop a lead-and-lag relationship with monetary decisions, often moving independently of them.

This disconnect is also visible in the overnight indexed swap market, where rates remain firm as the market has priced in the possibility of rate hikes a year ahead, signalling limited confidence in the durability of the easing cycle.

This has created parallel worlds. The RBI operates in one, where inflation is near target, growth remains resilient, liquidity is gradually improving, and the policy rate is judged appropriate. The bond market inhabits another, where funding conditions at the long end are shaped by issuance risk, term premia, and risk absorption capacity rather than by the policy corridor. The two worlds do not diverge permanently, but they do not converge on cue.

That convergence may occur with a lag. When borrowing clarity improves, balance sheets reset, and liquidity frictions ease, some order may return. Governor Sanjay Malhotra said that low interest rates would remain for a long period of time, that any further reduction would be for the MPC to decide, but it has not been ruled out.

Expecting bond yields to validate monetary policy comfort at this stage may be unrealistic, just as it may be imprudent for the MPC to react to yield movements driven by transient technical pressures.

Issue management tools can help bridge the gap, but only partially.

Open market operations, switches, buybacks, and durable liquidity injections can smooth volatility and prevent disorderly moves, yet they cannot fully neutralise the structural forces shaping long-end yields. 

It is clear that yield curve control is not part of the current policy toolkit, and there is little indication that the central bank intends to anchor long-end rates explicitly, especially when global yields are firming and the global economy is adjusting to tariff-led changes in the US.

Part of the disconnect also reflects how markets frame the borrowing challenge. The focus remains overwhelmingly on gross borrowing, which amplifies supply anxiety. For 2026–27, gross central government borrowing is projected at around ₹17.2 trillion, an imposing headline number. Net borrowing, however, is materially lower, closer to ₹11.7 trillion after accounting for redemptions. It is net supply that ultimately determines incremental funding pressure, yet it is the gross figure that dominates market psychology. As long as this distinction remains blurred, yields are likely to price risks that monetary policy neither intends nor needs to endorse.

The absence of yield targeting means the bond market must discover its own clearing levels, even if those levels temporarily appear inconsistent with the MPC’s macro assessment. That inconsistency should not automatically be read as policy failure. It is better understood as a reflection of a market driven by near-term mechanics rather than by the medium-term inflation-growth trade-off that guides monetary decisions.

The best-case scenario, therefore, is not an immediate rally engineered by policy signalling, but stabilisation. Demand needs to emerge at current yield levels, containing further upward drift even if a decisive decline remains elusive. Over time, as supply pressures ease and liquidity conditions normalise, the curve can migrate towards levels more aligned with the RBI’s stance.

Until that convergence occurs, it may be sensible to accept that monetary policy and bond markets are operating in parallel worlds. The disconnect is structural and cyclical, not ideological. Recognising that separation may be the first step towards interpreting both policy signals and yield movements with greater clarity.