India’s Bond Yields May Drift to 7.25% as Pressures Build

India’s government bond market has remained relatively composed in the face of a large external shock, but that stability may prove temporary. The 10-year government bond yield, currently anchored near 7%, reflects a combination of favourable near-term liquidity, contained issuance pressure in the first half of 2026–27, and steady demand from domestic institutions. Yet these supports appear increasingly transitory as underlying pressures begin to build.

Liquidity conditions remain comfortable for now. Core surplus is estimated at around ₹3 trillion and could rise due to the expected dividend transfer from the Reserve Bank of India at the end of May. This has allowed the system to absorb government borrowing without significant upward pressure on yields. However, this benign backdrop rests on several assumptions, including moderation in foreign portfolio outflows, rollover of the RBI’s short-term forward book, and a tapering of currency leakage after state elections. The first half of the year may remain supported by liquidity and manageable supply, but pressures are likely to build as issuance rises and fiscal dynamics come into focus.

More structurally, the supply outlook is set to become less forgiving. Fiscal pressures are beginning to re-emerge, driven by revenue foregone through fuel tax adjustments, a likely increase in fertiliser subsidies, and softer dividend flows from public sector enterprises. Additional policy measures, including potential credit guarantees, could further widen the deficit. The fiscal arithmetic is already shifting, with fuel tax cuts, higher fertiliser subsidies and softer dividends together implying a slippage of roughly 0.4% of GDP. Even a modest slippage of this magnitude would translate into higher borrowing requirements, increasing pressure on the long end of the curve.

At the same time, term premia are unlikely to remain compressed. As inflation risks persist and policy uncertainty rises, investors may demand greater compensation for holding duration. Recent signals from the Federal Reserve reinforce this backdrop, with the latest meeting reflecting a hawkish hold and multiple dissents against the current stance. With Jerome Powell expected to remain in place even as leadership transitions, policy rates in the US may stay higher for longer through 2027, sustaining a strong dollar environment. This, in turn, could keep pressure on the rupee through continued capital outflows, adding to upward pressure on domestic bond yields. This becomes particularly relevant in an environment where global yields remain elevated and domestic inflation expectations are showing signs of drift.

The current calm in bond yields, therefore, appears less a reflection of durable equilibrium and more a function of temporary alignment between liquidity and supply. As these conditions evolve, the 10-year yield is likely to drift higher, with 7.25% emerging as a reasonable anchor over the course of 2026–27.