3 days ago
Tale of two ends: What is the G-sec yield curve telling us?
The shape of the g-sec yield curve encapsulates the impact of monetary policy, government borrowing as well as market participants expectations. Its one a one stop report card for both policy as well as economy. So, what is the yield curve telling us in 2025?
The curve has steepened to levels last seen in 2022-2021. The decline in yield has taken place in the short-end, driven by RBI rate-cutting cycle of 100bps. The ultra-long bond yields (20yr to 50yr) have hardly moved despite significant policy easing by RBI. The apathy at the long-end reflects three factors – rising concentration of supply of ultra long bonds, lack of market expectation of further rate cuts and weak insurance demand.
In the first six months of 2025 (January to June), 32% share in the gross supply of centre and state government bonds was in the ultra-long end (20yr to 50yr). The rising concentration was driven by the need to extend the maturity profile of General Government debt and rising investor demand. However, the insurance sector demand has weakened recently with a sharp drop in premium growth. Lastly, the change in stance to neutral in the June policy has firmed expectations that the rate-cutting cycle could be over.
Looking ahead, there could be some support to ultra-long bonds if the H2FY26 g-sec calendar is less concentrated. That said, the redemption pressure is significant over the next 6 years (FY27 to FY32) with g-sec plus SDL redemption ranging from INR10.2tn in FY27 to INR12.6tn in FY32. Hence, if the concentration in the ultra-long bond segment is to be reduced, it could be shifted only to the 15-year point. The Centre is also conducting more switches this year to reduce the redemption pressure over the next few years, which is adding supply to the belly of the curve.
Short-end yields, which have seen a substantial reduction, got support from rate cuts by the RBI as well as liquidity infusion. Looking ahead, there is support from the RBI expected to cut policy rates by another 25bps in October / December. The OIS market is just beginning to partially price in a rate cut, post the June CPI print. The space to ease policy rates is derived from expectations that CPI inflation will significantly undershoot the RBI's estimate. FY26 CPI inflation is tracking at 2.7% v/s RBI's estimate of 3.7%. We expect rate cut expectations to firm up in the coming months. The more significant support to short-end yields will be the substantial surge in banking system liquidity, which is expected to peak at INR5tn by November / December. CRR will be reduced by 1% spread over September to November. This will infuse durable liquidity of INR2.5tn.
From a demand perspective, while insurance sector demand is weak, demand from other investor segments has held up, such as pensions and PFs, supported by strong AUM growth. Banks' demand, which was weak in FY25, is expected to be stronger in FY26. This is supported by not just the low cost of funds but also the expected moderation in the credit-to-deposit ratio. The substantial, durable liquidity infusion by the RBI is beginning to have an impact on deposit growth, whose momentum in Q1FY26 has picked up. The reduction in cost of funds for banks has resulted in them shifting towards the short end of the curve.
The steep yield curve also reflects that the market assessment of growth is not very negative. Hence expectation of a deep rate cut cycle isn't there despite a significant undershoot in inflation. Indeed, our growth assessment is similar to RBI's, with FY26 GDP growth expected to be 6.3%. The weakness in growth is seen in urban demand and private corporate capex. Meanwhile, growth will get support from rural demand, which is expected to recover with strong crop output and a rise in rural wages. Government capital expenditure, which had slowed last year due to the elections, is expected to pick up in FY26 both at the Centre and State levels.
Hence, the short-end of the curve could still see further reduction in yields, supported by a substantial rise in liquidity and the RBI still having space to ease rates. The long-end of the curve will see limited support as the majority of the rate cut cycle is over, and the demand-supply dynamic is less supportive. 10yr g-sec yield is expected to range between 6.15% to 6.35%.
(The author is Chief Economist, IDFC First Bank)
Disclaimer: This story is for educational purposes only. The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before making any investment decisions.
