Growing Disconnect Between RBI’s Policy Rate And Market Rates

50 – 75 Bps Hikes Expected Over The Course Of The Rest Of This Fiscal Year.

Suyash Choudhary, CIO – Fixed Income

FinTech BizNews Service

Mumbai, 11 May 2026: Bandhan AMC. has come out with "Macro & Bond Market update", authored by by Suyash Choudhary, CIO – Fixed Income:

Turning Defensive

Background

For the last few months, we have been focussed on the tension from external account pressures frustrating RBI’s ‘lower for longer’ theme. This can be envisaged under the framework of what is called ‘the impossible trinity’; which denotes the potential tension between exchange rate, capital flow, and monetary policy. Over the past year, one can see this tension in play in the case of India. This has led to monetary easing not achieving desired transmission in market rates.

Given this dynamic, it has made sense to us to turn more active on duration management. Thus, when the ‘lower for longer’ theme seemed to be dominating bond valuations, we had turned underweight duration. Over the course of the West Asia war, as market pricing on rate hikes turned quite aggressive, we had added back duration risk. We had preferred 14 and 40 years on the sovereign curve (since this curve has still been quite steep despite ongoing external account pressures) and front end (up to 3-4 years) on the corporate curve (since this curve is already flat reflecting elevated bank’s credit to deposit ratios).

New Developments

1. Duration of the shock: Given the size of the quantity shock on various commodities from the West Asia war, the length of the disruption was always of a major concern for markets and the global economy. With the buffer from inventories depleting, the sustained impact on supply has potential now for greater damage. There is also risk from production shutdowns increasing at source if offtake via the Strait continues to be compromised. Finally, the floor rates on a host of energy prices likely moves up the longer the conflict persists. This is because of rising buildup of ships that needs clearing once the Strait opens, the capacity of ports to process this flow, and the need for nations to rebuild depleted inventories and possibly build for even higher strategic reserves than before.

2. US growth is holding up, and alternate capital allocation themes are intact:  One reason to go overweight duration was also the very likely impact of the war on growth, and markets pricing that in central bank response functions. This theme would have played an important counterweight to the tightening in financial conditions that we are otherwise facing here in India owing to external account pressures. While this expectation may still hold from a few months’ standpoint, the immediate data reflects a resilient US economy. Furthermore, important capital allocation themes around the world linked to the AI story are if, anything, strengthening in momentum lately.

Implications

It can be easily seen that the above two developments are adding to the external account pressures and, by implication, to the growing disconnect between RBI’s policy rate and market rates. If this dynamic were to not change, the path of least resistance would be for RBI to bring forward tightening rather than market yields reverting to anchoring around existing policy rates. That said, it is important to clarify on two points: One, the route for policy rate normalisation will still be the traditional growth-inflation framework: a prolonged pressure on commodity prices, accompanied with continued currency pressures, will obviously change the predicted path of inflation. With average CPI for the current financial year easily likely to be in the 5 – 6% band, it almost automatically follows that RBI/MPC will have to undertake some rate hikes. As a base case one should expect 50 – 75 bps hikes over the course of the rest of this fiscal year. Two, this still doesn’t imply that a ‘rate defence’ is warranted to ease currency pressures. Thus, at whatever point, if market pricing starts to lean into the direction of aggressive rate hikes (more than what is warranted by the evolving inflation-growth dynamic), we would likely consider that as an opportunity to scale up market risk. To be clear, however, this is our thinking as of date and not a commitment.

Portfolio Strategy Update

Reflecting the evolving dynamics as discussed above, we have again gone underweight duration across a host of our funds (subject to individual mandates and positionings). The primary route undertaken for this has been via reducing our 14- and 40-year government bond positions. Recent relative stability in yields has made the decision somewhat easier, even as the primary reason for the change has been continuous evaluation of the underlying ‘impossible trinity’ tensions in context of the two new developments as described above.

One looks forward to developments that may allow for external pressures to ease including 1> conclusion to the war 2> effective capital flow garnering measures.  A sustainable turn to our capital flow dynamic, however, may also need some fatiguing of the AI allocation theme and / or return of some meaningful US rate cut expectations. Both are for now absent. It is also to be noted that our latest portfolio positionings reflect our current thinking. As always, these may change at any time in the future.