The Indian bond market experienced a whirlwind of activity following the recent monetary policy announcement by the Reserve Bank of India (RBI). The market's reaction, characterized by fluctuating bond yields and a shift in investor sentiment, prompts the question: Is the Indian bond market overreacting to these monetary policy changes?

According to B. Prasanna, Group Executive, Head - Global Markets & Proprietary Trading Group, ICICI Bank, the RBI's policy contained a few surprises. These included a larger-than-expected 50 basis points (bps) rate cut, an unexpected reduction in the Cash Reserve Ratio (CRR), and a change in stance from "easy accommodative" to "neutral," which the market did not anticipate. These elements collectively triggered a repricing of the interest rate trajectory.

Prior to the policy announcement, market expectations leaned towards a repo rate cut to 5.75%, followed by a further reduction to 5.5% in August. Some participants even considered a terminal repo rate of 5.25% or even 5%. However, the RBI's shift in stance and its clear indication of limited room for further monetary policy accommodation led to a recalibration of rate expectations.

Typically, changes in rate expectations manifest in the long end of the yield curve first. Following the policy announcement, yields on bonds with maturities exceeding five years, such as seven-year and ten-year bonds, increased. Conversely, the one-year bond yield declined, leading to an expansion of the spread between short-term and long-term yields.

Prasanna suggests that the market might be currently "overinvested" in bonds and is in the process of finding the right equilibrium, considering the change in stance. This has led to a shift in sentiment and some exiting of bond positions across the curve.

Looking ahead, Prasanna anticipates a new equilibrium in the bond market within the next week or so. As interest rates stabilize, influenced by factors such as falling inflation and anticipated rate cuts in the United States, investors may favor the short end of the yield curve, up to five or seven years. In contrast, the long end of the curve might underperform. He also suggested the terminal repo rate might target 5.25%.

Several factors could contribute to this potential stabilization and shift in investor preference. A clear trajectory on rates from the RBI is fostering confidence in the market. Positive domestic macroeconomic factors are also helping the Indian bond market. Furthermore, if US bond yields exhibit volatility, Indian bond yields could potentially move in a different direction, possibly falling below 6%.