India's Central Bank Liquidity Surge Fuels Short-Term Bond Rally: A Strategist's Perspective

The Reserve Bank of India (RBI) has unleashed a torrent of liquidity in early 2025, injecting ₹6.6 lakh crore ($79.5 billion) into the financial system through open market operations, foreign exchange swaps, and cash reserve ratio (CRR) cuts. This aggressive monetary easing has driven government bond yields to multi-year lows, with the 10-year benchmark yield plunging to 6.32%—its lowest since November 2021—and short-term yields like the three-year and five-year bonds falling 5–6 basis points to 6.12% and 6.17%, respectively. Analysts and strategists, including those at Nomura, argue that this liquidity-fueled environment could sustain a rally in short-term bonds while indirectly supporting equity markets.

The RBI’s Liquidity Playbook

The RBI’s strategy has been twofold: surplus liquidity creation and policy rate adjustments. By April 2025, the central bank had targeted a liquidity surplus of ₹2.20–2.50 trillion ($25.6–29.3 billion), aiming to anchor short-term rates near the repo rate. The Weighted Average Call Rate (WACR), a critical gauge of overnight borrowing costs, fell to 6.21% by mid-March—nearly matching the 6.25% repo rate—a clear sign of stabilized liquidity.

The central bank also reduced the repo rate by 50 basis points to 6% by April 2025, with further cuts anticipated. This dovish pivot has been underpinned by easing inflation, which dipped to 3.6% in Q1 2025, well within the RBI’s 4% target band.

Nomura’s Bullish Case: Bonds as the Catalyst for Equities

Nomura’s strategists, including Craig Chan, highlight that the RBI’s liquidity surge creates a “sweet spot” for Indian markets. Falling bond yields reduce risk-free rates, making equities more attractive relative to fixed income. The brokerage has raised its Nifty valuation multiple to 19.5x forward earnings, assuming risk premiums remain stable.

Key drivers for this optimism include:
1. Foreign Portfolio Inflows: Nomura projects $15 billion in FPI inflows into Indian debt by December 2025, with a stronger rupee (targeted at 84/$1) acting as a magnet for dollar-denominated investors.
2. Global Dollar Dynamics: A weakening U.S. dollar index (trading at a three-year low of 97.9) and expectations of three Fed rate cuts by year-end have eased pressure on emerging markets, including India.
3. Corporate Funding Costs: Short-term corporate borrowing costs, such as certificates of deposit (CDs) and commercial papers (CPs), have narrowed significantly against government bonds, easing cash flow strains for businesses.

The Rupee’s Role in the Rally

The Indian rupee’s appreciation—up to 85.12/$1 by April from a February low of 87.92/$1—is a critical tailwind. Nomura attributes this to the RBI’s accumulation of $677.8 billion in foreign exchange reserves and its proactive management of dollar purchases. A stronger rupee not only reduces import costs but also attracts foreign capital, creating a virtuous cycle for bond and equity markets.

Structural Challenges and Risks

While the outlook is bullish, risks linger. Banks have parked ₹2 trillion ($23.4 billion) in the RBI’s overnight facility, signaling caution in lending despite the surplus. Meanwhile, sectors like housing and automobiles face headwinds: residential property prices have surged 10–34% in major cities, while auto sales dropped 7% YoY in February due to stagnant rural wages.

Globally, U.S. tariffs on Indian pharmaceuticals and potential oil price spikes pose downside risks. The RBI itself has trimmed FY2026 GDP growth to 5.8%, below the street’s 6.5% estimate, underscoring the fragility of the recovery.

Conclusion: A Rally Anchored in Liquidity, but Not Without Limits

The RBI’s liquidity measures have undeniably fueled a short-term bond rally, with yields like the three-year bond hitting 6.12%—levels not seen since 2021. Nomura’s analysis underscores that this environment could sustain equity valuations if risk premiums remain contained. However, the rally’s longevity hinges on several factors:
- Liquidity Sustenance: The RBI must maintain its surplus target of ₹2.20–2.50 trillion, avoiding a repeat of 2024’s liquidity crunch.
- Global Stability: A weaker dollar and Fed easing are critical to keeping FPI inflows positive.
- Corporate Transmission: Banks must lower lending rates meaningfully to translate bond yield declines into real economic growth.

With short-term yields already near 6%, further declines to 6% or below—projected by market participants—would require aggressive rate cuts and sustained FPI inflows. While risks exist, the confluence of monetary easing, rupee strength, and nominal GDP growth (projected at 6.5%) positions India’s bond market for a sustained rally in 2025. For investors, this is a story of liquidity-driven optimism—a rally fueled by central bank actions, but one that demands vigilance to external shocks.