Hard to fathom, but yet another year is closing. We say this since, at least to us, it feels as if this one went by faster than usual. Don’t get us wrong, it isn’t that we had a very easy time of it so that the passing of the year didn’t register. Quite the contrary, most of it has been quite fatiguing for bond investors. Looking back on the last annual note (Click here), we find we got many of the macro set up calls right. We had called time out on dollar strength and US yields rising, had opined against risks of yuan devaluation that many were fearing then, and noted both rate cuts and OMOs were coming in India. However, before you rush in with congratulations, we must hasten to add that our final prediction of this benign influence positively rubbing off on Indian bonds hasn’t met with quite the success that it should have. This is one amongst many of the strange things that one has seen in play this year. We delve below into our list of such things.
The Relative Resilience of the US Economy
Almost a consistent feature of the post pandemic world has been the stronger than generally expected growth of the US economy. While growth slowed over 2025, it was still better than what most would have expected at start of the year given the twin supply shocks on goods (tariffs) and labour supply (immigration control). As it turned out, a combination of loose financial conditions, delayed rise in average tariffs (at least to the consumer), and a surge in AI related private capex all contributed to support growth, so that while it slowed it didn’t fall off a cliff. Also, despite fears with respect to continued rise in US bond yields, these also were better behaved through the year as fiscal deterioration got capped with tariff revenues, inflation pass through of higher tariffs seemed weaker and / or delayed, and duration supply was actively curbed. With the US story stabilizing, and the narrative in some other key developed markets (DMs) wobbling a bit, the dollar stopped weakening as well.
Having looked for a weaker dollar to increase degrees of freedom for emerging markets this year, the absence of further weakness here has been a monitorable for us and we flagged the same a few months ago. That said, as the year ends, the dollar is more treading water than showing any concrete direction. The prognosis is mixed, with the bullish arguments flagging the latest budget providing fresh impetus to consumers and business spenders over the first part of the new year, and limited room for the Fed to cut as services inflation remains sticky and pass through from tariffs finally reaches the consumer. On the flip side, the bearish arguments for the dollar include AI capex boom fatiguing, consumer weakness (hitherto being evidenced as an accentuated “K”) getting more pronounced on tariff pass throughs, and the Fed undergoing a change in reaction function under a new Chair and choosing to cut more.
The Fed’s Dilemma
The Fed has had it tough for a while now. It struggled with the outbreak of inflation post-pandemic, facing criticism for being reactive on rate hikes and continuing with balance sheet purchases, particularly of mortgage assets, for much longer than was perhaps desirable. Indeed, the point about balance sheet expansion has lately again become the subject of much debate including the examination that perhaps the Fed needed to be more conventional with its monetary policy, reserving tools like quantitative easing for the direst of circumstances.
To be fair, a lot of analysts didn’t see the post pandemic inflation coming. Many thought the supply disruption driven rise in prices would be temporary and under-appreciated the role of large fiscal transfers of the time in generating inflation. Also, despite the catch-up hikes the Fed had to do, the economy seems to have fared decently, even as some of the underlying dynamics may be sub-optimal. Finally, inflation expectations in the US have remained well anchored thereby demonstrating that there is no serious doubt with respect to assessment of Fed’s credibility in meeting its target objectives.
That said, the Fed finds itself again in less than an enviable place. Its dual mandate of inflation and employment are in tension. It assesses that rate setting is largely at neutral levels and yet financial conditions seem to be loose, driven by higher asset prices and tight credit spreads. Even as the labour market seems frozen and the unemployment rate has ticked up, aggregate consumption seems to be holding up well owing to the so-called “K” shape getting more pronounced as asset owners and net savers continue to do well. Inflation has eased and the general prognosis is that it may ease further. However, this assessment is made with low confidence as a lot of tariff pass through is yet left, there is some stickiness to aspects of core inflation, and the latest context is of the Fed having missed its inflation target for a few successive recent years. The uncertainty is reflected in greater divide within the FOMC members. Finally, Fed leadership is poised to change soon and there is a chance that its reaction function undergoes some change post that.
The Continued Robustness in China’s Trade Surplus
Given the relatively weak state of domestic demand, exports have been a key engine of growth for China. While US-China tariffs rates have eased considerably from their peak earlier in the year, they nevertheless have posed a headwind to China’s exports. Given this backdrop it has been remarkable to see a fresh high on China’s goods trade surplus.
As the chart below shows, after an early year dip, China’s trade surplus has rebounded sharply, with the run rate tracking higher than last year for non-US geographies for the most part.
India’s Very Low Inflation
India has seen a remarkable fall in inflation this year. While this has been aided by the volatile food price elements which will soon reverse, even core components of inflation have been quite subdued. Indeed, the RBI/MPC observed recently that underlying inflationary pressures may be even lower as the impact of increase in price of precious metals is about 50 bps.
The low inflation environment has also reflected in nominal growth slowing. While some part of this may reflect statistical phenomena, the general slowing of nominal growth is also corroborated by some slowing in other variables as well like tax collection (even adjusted for tax cuts). The slowdown is partly explained by relatively tighter monetary policy between late last year and early this year. This has been reversed with both liquidity and policy rates easing, alongside regulatory easing. The lagged effect of the reversal will therefore reflect in a rebound in nominal growth rate as well. While we are in another phase of forex intervention led domestic liquidity drain, RBI is now proactively ensuring that adequate liquidity gets replenished.
There is, however, another component to the nominal slowdown and drag from this source may persist for the foreseeable future. That is, China’s export of domestic excess capacity to the rest of the world and the consequent deflationary impulse that this imparts. While being conscious that correlation doesn’t imply causation, we nevertheless find the chart below noteworthy.
Given that there is no early resolution to China’s excess capacity, this should broadly put a lid on global manufacturing inflation and is one of the reasons, we think RBI will be able to keep policy rates lower for longer.
India’s External Account Dynamics
Rupee has faced depreciation pressures this year despite broad dollar weakness for much of the year. This is largely owing to muted capital flows leading to the possibility of the second consequent year of negative balance of payment for us, a rarity. With the rupee having adjusted substantially, and with nominal growth rate hopefully rebounding a bit, it is likely that capital flows start returning in the year ahead. There is also possibility for greater bond flows, nudged maybe by a much looked forward to bond index inclusion.
While capital flows are by nature volatile, developments on India’s goods trade account over the past few years have been noteworthy.
The chart above shows evolution of India’s goods trade balance by geography, pre and post the pandemic. What stands out is how the deficit with China and HK has widened post the pandemic. This correlates with the point made earlier that China has needed to (and been reasonably successful at) export out its excess capacity. The same may pose a substantial headwind to a broad-based manufacturing capex revival in India, as well as to any significant revival in core inflation. For that reason, we think a combination of weaker currency and lower for longer policy interest rates may be exactly the right combination of macro-policy needed. This assumes (hopes for) a benign US dollar environment: that is, the dollar should at worst be side-ways and not re-enter a period of unilateral strength that again cuts degrees of freedom for emerging markets.
The Missing Risk Appetite for Indian Bonds
The year has seen 125 bps rate cuts and INR 6 lakh crore plus of bond purchases from RBI. Had this information been upfronted provided at year beginning and forecasts sought for year closing 10 year government bond yield levels, a series of 6ish forecasts would have ensued, we would imagine. And yet at the time of writing the 10 year is obstinately stuck around 6.60%, a full 135 bps over the repo rate. Even more starkly, with a last rate cut still not ruled out and any smell of a rate hike still far, far away, the 5 year yield is more than 100 bps over the repo. The long end of the curve is similarly in its own orbit, though admittedly this is a shade more exotic in terms of demand and supply versus the more ‘conventional’ 5 and 10 years.
In the chart above, we track the 5 year to 1 year spread as well as the 30 year to 10 year spread. Before we proceed with observations here, some caveats may be in order: it is natural for 5 year to 1 year to steepen towards the end of the rate cut cycle. However, as observed before not only is a last rate cut still possibly in play but one is subsequently looking for a long period of hold on the repo rate. Also, the 10 year to 5 year spread is barely 25 – 30 bps. This leads to 2 observations: One, the yield curve is generally steep, possibly reflecting lack of risk appetite across segments. This point is important since till very recently it was being made only with respect to the long end of the curve. Whereas it can be argued that the 5 year is a better gauge to track effective transmission of monetary policy rather than the 30 year. Two, the 10 year point is generally expensive in our view and that shows as flatness to 5 year as well as steepness to 30 year.
We have been discussing the following two charts almost through the year, but they deserve another look, nevertheless. The first one tracks the rise in weighted average maturity of issuances for both centre and state borrowings. These have risen considerably over the past few years and there is a strong likelihood that, at least for the centre, a more serious look towards reducing this somewhat is taken from FY 27 onwards. The most obvious way to do this is to shift some borrowing to treasury bills. This will both make a notable dent to average maturity of issuances as well as address the point that risk appetite is now missing across the curve and not just at the long end. However, the second chart establishes why average maturity of borrowings may still remain reasonably high (even after some adjustments) given that the government is also endeavouring to smoothen maturity profile of its borrowings.
In our current view, we prefer the 4 – 7 year government bond segment as a relatively pure play on: 1> a long period of current or 25 bps lower than here repo rate 2> imminent further OMOs to address a progressively deteriorating liquidity environment. We currently don’t like longer maturities than this considering the lack of generally weak risk appetite and the still significant duration supply likely in years ahead, despite some probable tweaks to auction profile as discussed above.
To further try and quantify prospective bond supply ahead, we present a table below. Here we have assumed various scenarios for central government borrowing under varying assumptions of their share in financing the central fiscal deficit. State borrowing assumption is kept static in this analysis.
As can be seen, gross supply to market is likely to rise substantially from the upcoming financial year. This is even assuming some move away from dated government securities borrowing to other sources of financing, including treasury bills. Thus, even accounting for OMOs yet to come over Q4 FY 26, term premia should be wide enough to reflect the upcoming supply.
The corporate bond curve should see somewhat different dynamics. Here the pressure is from the 1 year point and the curve beyond 3 – 4 years is quite flat owing to lack of supply in longer tenors. Thus the 2 – 4 year points look relatively more attractive here, in our view.
Overall, though, investors should assess both portfolio duration (to be clear, duration exposure should be capped at moderate levels) as well as segment selection on SLR and non-SLR curves (for relative value points) when making allocation decisions in our view. Also, investment horizons should be probably longer than usual given more underlying market volatility. As to the question: why bother with any fixed income allocations at all beyond liquid and / or overnight funds? The answer is that we are likely ‘low for longer’ on overnight policy rate that makes relatively ‘riskless’ investments that much more unappetizing.
Stranger Things
That concludes most of our list of strange observations for the year. There is one, however, that we saved for the last and looks to us as being even stranger. This one has given us much food for thought this year: the process of building and executing a view framework.
For your view to be robust, it obviously needs to be thought through carefully. For the business we are in, it is also good practice to communicate this well to investors. So far so good, but here’s where things get strange: It probably doesn’t serve you well if the market price action immediately after your formulating and executing a view is extremely to your advantage. This ends up emboldening you further that you have been analytically robust and operationally proactive and discourages a more profound enquiry on whether some of the building blocks may be flawed.
In all fairness though, the assumptions underlying a framework can change as well, basis evolving market and macro circumstances. This is well understood and appreciated. Rather, the observation here is of degrees of inertia: the more time you spend building and communicating the view and framework, the bigger the likelihood of inertia for subsequent change. This is especially so if the initial price action is very supportive of your thesis.
This last bit of analytical indulgence is not meant as any sort of a self or general warning to desist from taking views or building frameworks. Much better to treat this as yet another learning from experience but with the caveat that it is unlikely the next time is going to be the same.
And that about fully wraps up our list of strange things. May you have a wonderful new year and may the only strangeness you encounter is one that comes as serendipity so that, even though it may not fit in your logical order of things, it nevertheless leaves you smiling if you happen to cross paths with it.
Wishing You A Very Happy New Year.
Disclaimer:
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of Bandhan Mutual. The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the security, if any, may or may not continue to form part of the scheme’s portfolio in future. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. The decision of the Investment Manager may not always be profitable; as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement/document as may be required from time to time. Neither Bandhan Mutual Fund / Bandhan Mutual Fund Trustee Limited / Bandhan AMC Limited, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information. Past performance may or may not be sustained in future.