Indian government bonds have outperformed since RBI’s capital flow liberalisation measures on June 5, with the curve bull steepening as the front end led the rally.
The 2Y IGB yield has compressed by 30bps since the announcement, with the move largely driven by a repricing of RBI policy expectations. The June 5 package helped stabilise the INR and removed the immediate need for a defensive rate hike, prompting a rapid unwind of front-end hike pricing. Yields declined further this week, supported by positioning ahead of the June 29 front-end buyback, which has generated a more mechanical bid for short-dated paper. At this stage, the scope for further decline in 2Y yields appears more limited. Market pricing has largely faded expectations of an August hike, while Fed tightening expectations have firmed, driving a sharp narrowing in the 2Y IGB–UST spread. While RBI rhetoric suggests that a near-term rate hike is unlikely, risks remain tilted to the upside, particularly via food inflation. Should inflation dynamics deteriorate, current front-end pricing may prove vulnerable, with scope for a relatively rapid rebuilding of hike expectations.
The rally at the long end has been more measured (-17bps) but remains underpinned by a more durable, structural bid from ongoing foreign inflows into index-eligible bonds following the relaxation of capital rules. Foreign participation has increased meaningfully this month, and these inflows are likely to translate into a rise in system liquidity in the coming weeks, reinforcing the supportive backdrop. Unlike the front-end move, which largely reflects a one-off repricing, the long-end rally appears anchored in an ongoing reallocation, suggesting that the 10Y offers further room to compress. Notably, RBI Governor Malhotra confirmed yesterday that further ease-of-investing measures are reportedly in the pipeline and could be announced in the near term, signalling that the reform package remains in progress and providing continued tailwind for longer-dated IGBs.
Overall, the synchronised rally across the IGB curve reflects differing underlying drivers. The outperformance at the 2Y is largely backward-looking, driven by the unwind of an embedded policy hike. In contrast, strength in the longer tenors appears more forward-looking, anchored by a scaling up of structural capital inflows. Taken together, this divergence suggests some scope for modest curve flattening ahead.
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