RBI Communication Misstep Drives 10-Year Yield Spread Over Repo to 100 bps

The spread of the 10-year government bond yield over the repo rate touched nearly 100 basis points on Tuesday. At 6.49%, the yield also hit the highest level since April. This was despite steady global yields, subdued crude prices, softest inflation in eight years, and ebbing overnight rate volatility. 

But the explanation lies not in external shocks. It lies in the Reserve Bank of India’s signalling, which convinced markets that the central bank is closed for more rate cuts. 

If not that, then the bar for any further rate cut is now exceptionally high.

A change in stance can matter more than the rate move itself. In June, the central bank delivered a larger-than-expected 50-basis-point repo cut and pledged liquidity injections through a reduction in the cash reserve ratio. Yet the RBI paired the move with a shift from an accommodative to a neutral stance. 

That change effectively told the market to stop expecting further easing, removing the very anchor that could have kept term premiums in check. The August review reinforced this message, citing core inflation and model-based projections of headline inflation near 5% next year as reasons to be cautious, despite current headline inflation at multi-year lows.

For the bond market, that combination has been damaging. 

A broad yield range of 6.25% to 6.50% was expected through the quarter, but the top end is now being breached. Buyers are scarce even at these higher yields, as portfolio managers see no clear catalyst for a sustained rally. The result is a self-reinforcing cycle of caution, with few willing to add duration risk in the absence of supportive central bank guidance.

Market Strain
Underlying demand-supply dynamics have added to the pressure. Fresh fiscal worries followed the release of data showing that net direct tax collections for April 1–August 11 were ₹6.64 trillion, down 4% year on year, amounting to just 26.3% of the government’s 2025-26 target. That shortfall has fuelled speculation of higher borrowing later in the year, adding to an already heavy gilt supply. 

The government’s approval of ₹300 billion in compensation to oil marketing companies for losses on subsidised cooking gas further added to those concerns. 

State development loan issuance is putting additional strain on long-end demand, and cut-off yields at recent state bond auctions have been sharply higher than expected, underscoring weak investor appetite.

The new RBI rules, which have made it tougher for direct sales from the Held-To-Maturity book, mean investors cannot position for capital gains when yields eventually fall, further reducing their appetite for fresh purchases. The absence of open market operations, given the scheduled CRR cuts, leaves the market without an important buyer of last resort.

The result is a widening of term spreads to levels that were last seen several years ago.

The longer the maturities, the more pronounced the premium, with state loans trading at multi-year highs over equivalent central government bonds. This is happening against a backdrop of subdued global rates, underlining that the pressure is domestic and policy-induced.

For the broader economy, these shifts are more than a market inconvenience. The government bond yield curve serves as the benchmark for all borrowing costs, from corporate debt to housing loans. Elevated yields at the long end push up corporate bond rates and slow monetary transmission, as banks hesitate to reduce lending rates. The spread of almost 100 basis points over the policy rate signals that the intended easing impulse from earlier cuts is not flowing through as planned.

The credibility cost of this communication misstep is significant. Markets are forward-looking and price not only current policy but the trajectory they believe it implies. By removing the accommodative bias so abruptly, the RBI has boxed itself into a position that will be harder to reverse if growth disappoints. Should new data show a sharper slowdown or if external shocks such as higher US tariffs on Indian exports feed into weaker activity, the central bank would first have to shift its stance again before cutting rates. That sequencing would make any renewed easing more market-sensitive and potentially less effective.

Growth risks are not abstract. High-frequency indicators show consumption softening, with anaemic two-wheeler and passenger vehicle sales, muted non-oil, non-gold imports, and lacklustre corporate earnings. Private investment remains hesitant, and credit growth has lost momentum. At the same time, the fiscal backdrop is tightening, as weaker revenues and pre-committed spending plans limit the scope for countercyclical stimulus.

The market’s frustration is that these conditions warranted a more gradual approach to policy recalibration. By delivering rate cuts in smaller steps while keeping the accommodative stance, the RBI could have extended the easing cycle’s influence and allowed transmission to strengthen over time. That would have maintained downward pressure on yields, ensured a better alignment between short-term rates and long-term borrowing costs, and preserved flexibility to respond to incoming shocks.

Policy Mismatch
Instead, the current configuration risks a policy mismatch. Fiscal policy is constrained, monetary policy has signalled an end to easing, and bond markets are left to absorb heavy supply without reassurance that term premiums will be anchored. This is a poor backdrop for sustaining investment or supporting growth in the face of weaker external demand.

The central bank’s communications have compounded the uncertainty. While emphasising the importance of anchoring inflation expectations, the RBI has also shifted its narrative towards variables such as core inflation that are not its statutory target. This has led investors to question whether the policy framework is moving the goalposts, creating ambiguity about what will trigger a shift back to an easing bias. In a market as sensitive to guidance as India’s, such ambiguity is quickly priced into higher yields.

Long-term investors, both domestic and foreign, value stability and predictability in the yield curve. The present steepening undermines that stability, with implications beyond the debt market. Higher sovereign yields raise the government’s interest burden, squeeze fiscal space, and crowd out private borrowers. For corporates, the elevated cost of capital can defer or downsize planned investments, slowing job creation and economic momentum.

The lesson from this episode is not that large rate cuts are inherently problematic. It is that the sequencing, tone, and stance accompanying them are critical to sustaining their effect. Abruptly closing the door on further easing after frontloading support may appear decisive, but it sacrifices one of the central bank’s most valuable tools — the ability to shape expectations in a way that smooths market functioning and enhances transmission.

As external risks mount, including trade tensions, volatile capital flows, and potential supply-side shocks, policy agility will be at a premium. The central bank retains the capacity to restore that agility, but doing so will require recalibrating its guidance and re-engaging with the market’s need for clarity. A more patient approach, allowing the current easing measures to work through the system while keeping options open, would better balance the dual objectives of stability and growth.

In central banking, silence can be powerful, but so can the right words at the right time. For India’s bond market, the words chosen in June and August have proved costlier than any single rate move. Rebuilding that trust will be essential if the yield curve is to return to its role as a reliable anchor for the economy’s cost of capital.