India's Government Bonds: Navigating Yields Amid Global Policy Uncertainty

The interplay of global monetary policy and domestic liquidity management has created a pivotal moment for Indian government bonds. As the Reserve Bank of India (RBI) tightens liquidity through targeted measures, while the U.S. Federal Reserve adopts a cautious stance, investors are faced with a narrowing yield window. This divergence presents a tactical opportunity to overweight medium-term bonds (3-5Y) to capitalize on reduced inflation risks and evolving debt supply dynamics.

RBI Liquidity Withdrawals: A Short-Term Yield Boost

The RBI's June 2025 policy shift—cutting the repo rate by 50 bps to 5.50%—was accompanied by aggressive liquidity absorption. A ₹1 trillion reverse repo auction aimed to drain a banking system surplus averaging ₹2.76 trillion/day, pressuring short-term yields. The five-year bond yield rose to 6.02%, while the benchmark 10-year yield stabilized near 6.26%, supported by falling U.S. Treasury yields and easing oil prices ().

This divergence reflects the RBI's dual mandate: supporting growth via rate cuts while curbing excess liquidity through reverse repo auctions. Short-term OIS rates (e.g., 1Y at 5.52%) rose, signaling tighter near-term conditions.

Fed-RBI Policy Divergence: A Global Crossroads

While the RBI eases rates, the Fed's reluctance to cut rates—even as U.S. inflation cools—has kept global yields elevated. This divergence is critical for Indian bonds:
- U.S. 10Y Treasuries at 4.30% (July 2025) remain above India's 6.26%, offering a yield premium.
- Oil prices, down to $68/bbl, have reduced inflation risks, easing pressure on RBI to tighten.

The Fed's caution creates a "sweet spot" for Indian bonds: lower oil-driven inflation allows the RBI to maintain accommodative policies, while global rates remain anchored.

Why Medium-Term Bonds (3-5Y) Offer the Best Trade

1. Carry Advantage and Liquidity
Medium-term bonds offer a 150 bps yield spread over short-term rates, with ample liquidity from domestic institutions. State-owned banks' demand for mid-term debt to hedge liquidity risks has bolstered this segment.

2. Inflation and Geopolitical Tailwinds
The Iran-Israel ceasefire has reduced oil price volatility, while a normal monsoon (projected to boost GDP by 0.5-1%) supports disinflation. This reduces the risk of abrupt RBI policy shifts.

3. Debt Supply Dynamics
The government's ₹360 billion bond sale in Q3 2025 may pressure longer-dated yields, making mid-term bonds safer.

Risks and Mitigation Strategies

• Geopolitical Volatility: Ongoing Russia-Ukraine tensions or a Fed surprise rate hike could disrupt yields.
• Monsoon Underperformance: A weak monsoon could reignite inflation fears.

Mitigation:
- Overweight 3-5Y bonds to avoid long-dated exposure to Fed risks.
- Use swap spreads (e.g., 5Y OIS vs. bond yields) to gauge liquidity and policy expectations.

Investment Recommendation

Overweight 3-5Y government bonds:
- Target Yields: Aim for entry points near 5.8-6.0% for 5Y bonds, leveraging the carry advantage.
- Exit Triggers: Sell if U.S. 10Y yields rise above 4.5% or India's CPI inflation exceeds 4.5% in Q4 2025.

The RBI's calibrated liquidity management and the Fed's cautious stance have carved a unique window for bond investors. By focusing on medium-term maturities, portfolios can capture yield opportunities while mitigating global and domestic risks.