Liquidity, not just rate cuts, holds the key to cooling Indian bond yields

Despite a 125-basis-point rate cut by the Reserve Bank of India (RBI) in 2025, government bond yields have refused to cool off, leaving a growing disconnect between the bond market and policy actions.

Since the beginning of February, RBI’s Monetary Policy Committee has cut the policy repo rate by 125 bps. While yield on the benchmark 10-year government bond has fallen from a high of 6.72% in February to 6.24% in May, it reversed those gains to 6.50% levels since late August when the US slapped 50% tariffs on Indian goods.

On Friday, yield on the 10-year government bond—the most liquid paper—ended at 6.60%, 10 bps higher since the rate-setting panel announced its latest 25 bps cut in repo rate on 5 December.

At the heart of the problem is liquidity. “You need liquidity. Lots and lots of it. To the tune of ₹2–2.5 trillion more,” a senior treasury official at a private bank said.

While RBI has announced open market operations (OMOs) and other liquidity measures, market participants argue these have largely been offset by foreign exchange interventions and bond redemptions, making it a transient form of liquidity rather than a durable one.

“Rate cut transmission to the bond market has been constrained by tight liquidity conditions, elevated supply expectations and global rate volatility,” V.R.C. Reddy, head of treasury at Karur Vysya Bank, said. “Liquidity is like oil to a vehicle, it lubricates the system and ensures smooth transition of rates; however, it is the durability of liquidity that matters more than transient infusions.”

“Whatever liquidity they are providing is going back into the system via FX intervention. Where is the actual liquidity?” the senior official asked, adding that without durable surplus liquidity, monetary transmission to bond yields simply cannot happen.

Deposit growth lag

This liquidity squeeze is colliding with weak deposit growth. Broad money (M3) growth has slowed sharply, reflecting muted real economic momentum. With deposits not growing fast enough, banks—the largest holders of government securities—have limited capacity to absorb fresh bond supply.

Excess statutory liquidity ratio (SLR) holdings, built up during years of sluggish credit growth, are now being drawn down to fund lending. The system’s credit-deposit ratio has risen from the mid-70s to above 80%, indicating that banks are deploying resources away from government bonds and into loans.

Banks’ SLR holdings were at 26.2% at the end of November, as against the requirement of 18%.

Deposit growth for the banking sector rose a little over 10% on year as on 28 November, lower than the 11% on year growth in the same period a year ago, according to the latest RBI data.

Further, with excess supply from state loans this year and a lack of participation from long-term investors such as insurance companies, provident funds and pension funds has created a clear demand–supply imbalance.

While Union government borrowing remains sizable, the pressure is compounded by rising state government issuance. Market participants are bracing for ₹4.5-5 trillion of state borrowings in the March quarter alone, a prospect that has pushed up term premia.

Term premia on government bonds are the extra compensation investors demand for holding long-term debt instead of rolling over short-term securities, covering risks like inflation and interest rate changes.

“If state borrowings go up without commensurate demand, you will see further yield pressure,” another treasury official said.

This backdrop explains why bond yields have risen despite policy rates falling. Investors believe that the rate-cut cycle is nearing its end, which is reducing expectations for further easing.

Path to recovery

At such points in the cycle, yield curves typically steepen rather than rally. Add to this global rate volatility, foreign bank balance-sheet constraints in December, offshore selling in the overnight indexed swaps (OIS) market and a depreciating rupee eroding foreign returns, and the upward pressure on yields becomes easier to understand.

So what could help? Market participants broadly believe these four steps could help.

First, aggressive liquidity infusion. Many argue that only large-scale OMOs of ₹2-2.5 trillion can meaningfully alter market dynamics. Also, traders want assurance that these are not merely to replace maturing bonds but to inject net durable liquidity.

OMO purchases are a monetary policy tool in which a central bank buys government securities from commercial banks, thereby injecting liquidity into the banking system.

“The market is keenly watching the RBI’s stance on roll over or maturity of over ₹6,000 crore of its forward book, which might push the central bank to aggressively infuse liquidity in the market and conduct OMOs,” a third treasury official said.

Second, foreign demand via index inclusion. The inclusion of Indian government bonds in the Bloomberg index is widely regarded as a positive development. Passive inflows would be automatic and stable, helping bridge the demand gap.

However, participants caution that while passive money will come, active investors need clarity on policy direction and currency stability, especially after taking losses on both rates and the rupee this year.

Third, an improvement in deposit growth. Several participants stressed that a sustainable rally in bonds ultimately requires healthier bank balance sheets.

“I think we need to see a better outcome on banking systems’ deposit growth, and that will, in turn, result in higher demand for HQLA (high quality liquid assets), and that will, in turn, bring some balance into the demand-supply issue,” Neeraj Gambhir, executive director at Axis Bank, said.

Market skewed

Finally, tax relief in the upcoming Budget. Calls have resurfaced for removing withholding tax on foreign investors and making capital gains taxation on fixed income more attractive relative to equities.

While many acknowledge that tax policy is a long-term structural issue unlikely to be tweaked tactically in the Budget, they believe that the current skew in favour of equities is starving the bond market of domestic retail participation.

“Calls for tax relaxation typically resurface during periods of FII outflows; however, tax policy is a structural, long-term consideration and is unlikely to be addressed as a tactical response in the Budget. Meaningful transmission will therefore hinge on durable liquidity and credible policy signalling rather than short-term fiscal incentives,” Reddy said.