Yields on Indian government bonds – issued by the Centre to raise funds to bridge its annual fiscal deficit, or the mismatch between its receipts and expenditure – have risen sharply in recent weeks in the wake of the war in West Asia due to the strain on public finances as expenditure mounts for things such as fertiliser subsidy and loss of revenue from the cut in excise duty on petrol and diesel, among others.

On Thursday, the most actively traded Indian government bond closed at 7.11%, up a massive 45 basis points (bps) from 6.66% on February 27. Bond yields have risen across the world, from the US to Japan, to multi-year highs as fears of rising inflation unnerve investors that central banks may start raising interest rates.

Bond yields vs price

Bond yields move in the opposite direction to prices. Rising bond yields are a sign of investors expecting higher interest rates in the future.

In India, opinion has begun to shift that the Reserve Bank of India’s Monetary Policy Committee may start raising the policy repo rate as early as next month – the rate-setting panel will announce its decision on June 5 – with the rupee’s non-stop fall seen as becoming a consideration for monetary policy, something the central bank has repeatedly said in the past is not the case.

On Thursday, Standard Chartered economists revised their prediction for Indian interest rates, saying they now expect the RBI to start increasing the repo rate by 50 bps to 5.75% over the June and August policy decisions. If there is no hike in June, the repo rate could be raised by 50 bps in ⁠August, they said.

“We also see a risk of additional 25-50 bps of hikes in FY27 if inflation turns out to be higher than we expect due to continued pressure from commodity prices and INR weakness,” economists Anubhuti Sahay and Saurav Anand said in a note.

Rate Action

It is worth recalling that the MPC had cut the repo rate by 125 bps in 2025. And markets seem to think that a similar turnaround is in the offing.

“For India, four-five rate hikes have been priced in by the OIS market over the next year. Markets are forward-looking, so they will react to conditions that they see maybe around six months ahead,” Gaura Sengupta, Chief Economist at IDFC First Bank, said.

OIS, or Overnight Index Swap, is a type of interest rate derivative used by financial market players to hedge the interest rate risk they face and is an indicator of interest rate expectations.

However, Sengupta said the rise in OIS rates does not necessarily mean the RBI will increase the repo rate in June as inflation is still subdued and that some of the movement in OIS rates is hedging-related. “If you’re long on bonds, you use OIS to cut your risks,” she said.

According to Sankar Chakraborti, Managing Director and Chief Executive Officer of Acuite Ratings and Research, the rise in Indian bond yields is “largely a reflection of a ‘global contagion’ rather than a definitive bet on domestic tightening”. “The current market behaviour suggests a defensive hedge against extreme ‘tail risks’ rather than a high-conviction bet that the RBI will immediately raise rates, especially as the central bank remains wary of stifling private investment,” he added.

Inflation trajectory

Even though retail inflation, which the RBI is mandated to target, has been subdued so far, inching up only slightly in April to 3.48% from 3.4% in March, producers are beginning to feel the heat from the war. In April, wholesale inflation surged to a 42-month high of 8.3%, and economists expect these input price pressures to soon be passed on to consumers.

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Which is why retail inflation forecasts are already being raised. While the RBI in April predicted headline retail inflation may average 4.6% in FY26, central bank watchers are closer to 5%, with Standard Chartered on Thursday raising its forecast by 20 bps to 4.9%. At the same time, the rupee’s fall – it nearly touched 97-per-dollar on Wednesday and is down 5.5% since the war began – raises the risk of imported inflation.

“A (rate) hike would help to anchor sentiment and consequently any second-order effects on the INR and/or inflation, in our view,” Standard Chartered said.

And pressure on the exchange rate is not expected to abate any time soon. In fact, Singapore’s DBS Bank on Wednesday raised its 2026 forecast for the rupee to a range of 95-100 per dollar from 90-95.

Should the RBI raise interest rates next month, it would not be the first to tighten monetary policy in response to the shock from the war. Most recently, on Wednesday, the Indonesian central bank surprised by raising its policy rate by 50 bps to 5.25%, noting that the increase “represents a further measure to strengthen Rupiah exchange rate stabilisation efforts against the impact of heightened global turmoil triggered by the war in the Middle East, as well as a pre-emptive measure to maintain inflation within the target corridor”.