India’s Bond Market Is No Longer Listening to the RBI

India’s bond market is behaving in a way that should make policymakers uneasy. Despite a deep rate-cut cycle, persistent inflationundershoots, and a macro narrative that still leans on growth resilience, long-term government bond yields have remained stubbornly elevated. At times, the yield curve has even bear-steepened, an outcome more typical of tightening phases than easing ones. This is not a transient bout of volatility. It reflects a more fundamental breakdown in how monetary policy transmits to financial conditions.

The numbers make the dislocation clear. Since the easing cycle began in early 2025, barely a quarter of the cumulative rate cuts have passed through to the 10-year government bond yield. In previous easing cycles, transmission was swift and decisive, with long-end yields absorbing most of the policy impulse. Even excluding the pandemic period, the current cycle stands out as the weakest transmission episode on record. The curve is steeper, spreads are wider, and conviction remains thin.

At first glance, this appears paradoxical. Inflation has undershot forecasts through much of 2025–26, forcing repeated downward revisions. Growth remains optically strong, at least in headline terms. The central government has made progress on fiscal consolidation since the post-pandemic years, and the Reserve Bank of India has complemented rate cuts with liquidity injections and supportive communication. In such conditions, bond yields would ordinarily fall, and the curve would flatten.

They have not. That failure suggests the bond market is no longer reacting to near-term macro comfort but is instead pricing deeper structural concerns.

Broken Transmission
The central issue is the rise in term premia. Investors are demanding compensation not for immediate inflation risks, which have eased, but for uncertainty around fiscal dynamics, supply pressures and the long-term coherence of the policy framework. This behaviour mirrors trends in developed markets, where long-end yields have remained elevated despite rate cuts, reflecting fears of fiscal dominance and weakened policy credibility. India’s situation is less extreme, but the parallels are increasingly difficult to ignore.

What makes this cycle distinct is the simultaneity of constraints across investor classes. In earlier easing episodes, even when one pocket of demand weakened, others stepped in. This time, banks, insurers, mutual funds and foreign investors are all constrained at once. Corporate bond spreads have widened during an easing cycle, something rarely seen in the past, underscoring how the failure of sovereign transmission is spilling across asset classes.

The longer this persists, the more the bond market begins to question not the intent of policy, but its effectiveness.

Fiscal arithmetic sits at the heart of the market’s unease. While the Centre has consolidated meaningfully, state finances have come under growing strain. State-level borrowing has risen faster than central issuance, and spreads on state development loans have widened, signalling investor concern. Over time, the distinction between Centre and state borrowing is blurring from a market perspective, as both draw on the same pool of long-term capital.

This convergence matters because it increases the effective duration the market must absorb. It also comes at a time when the buffer between nominal GDP growth and bond yields has narrowed sharply. In a low-inflation environment, that gap is critical. When nominal growth comfortably exceeds borrowing costs, debt dynamics are forgiving. When it compresses, even modest fiscal slippage or growth disappointment can unsettle long-term investors. The bond market appears to be pricing this vulnerability well in advance.

Supply dynamics have amplified these concerns. Issuance shifted decisively toward longer maturities in recent years, responding to strong demand from insurers and pension funds. That demand has now peaked. Insurance asset growth has slowed, pension allocations have tilted toward equities, and banks have turned cautious after sustained mark-to-market losses. Yet supply has been slow to recalibrate, particularly at the long end, especially at the state level.

Demand fatigue is no longer episodic. It has become structural.

Policy Exit
The foreign exchange dimension has further complicated the picture. In this cycle, policymakers have prioritised domestic financial conditions, allowing the rupee to weaken while easing rates. In theory, that trade-off should have supported bonds. In practice, it has failed. Currency weakness has heightened fears of capital outflows and imported inflation, reinforcing term premia rather than compressing them. Stress in the overnight indexed swap market and renewed foreign selling highlight how tightly FX and rates are now intertwined.

This interaction has created a self-reinforcing loop. Currency softness pushes yields higher, higher yields weaken risk sentiment, and that feeds back into FX pressure. The classic trade-off between exchange-rate stability and interest-rate management is no longer delivering clean outcomes. Instead, it has introduced an additional layer of uncertainty into bond pricing.

The policy dilemma is therefore stark. Aggressively forcing yields lower risks distorting price discovery and encouraging complacency among borrowers and investors. Allowing the current dislocation to persist entrenches a higher-for-longer cost of capital that undermines growth, strains fiscal arithmetic and weakens monetary transmission.

The way out lies in structural recalibration rather than tactical intervention. Gradually reducing long-duration issuance and rebalancing borrowing toward shorter maturities would ease pressure at the long end. Better coordination between central and state borrowing calendars could prevent supply from overwhelming demand. Addressing the tax bias that disfavors fixed-income investments relative to equities would help revive domestic bond demand without relying on captive buyers.

Liquidity policy also matters. Past easing cycles ended with liquidity surpluses large enough to reinforce transmission. In this cycle, balance-sheet expansion has been constrained by foreign exchange dynamics, limiting the durability of liquidity support. More sustained liquidity infusion, alongside clearer communication on borrowing and liquidity management, could help restore confidence without undermining market discipline.

Ultimately, the bond market is not rebelling against the central bank. It is signalling that monetary easing alone cannot repair a framework strained by fiscal pressures, supply mismatches and shifting investor behaviour. In a low-inflation economy, the cost of capital should fall, and when it does not, despite policy intent, markets are questioning whether fiscal strategy, market structure and monetary tools are aligned with the new macro reality.

Until that alignment improves, India’s bond market will continue to price caution where policymakers see comfort, and rate cuts will look powerful in theory while remaining muted in practice.