Indian govt bonds drop on Fed rate hike bets, benchmark trades at discount

Indian government bonds experienced a drop on Monday, with the benchmark paper trading below par as hawkish comments from the US Federal Reserve chief raised expectations of an interest rate hike in September. The yield on the benchmark 6.94% 2036 bond reached 6.9480% by 10:45 am IST, after closing at 6.9108% on Friday. Earlier in the session, the yield spiked to 6.9538%, its highest level since June 11.

Traders noted a distinct bearish sentiment as a more hawkish Federal Reserve, rising crude prices, and the Indian central bank's readiness to act on inflation left limited room for yields to ease. US Treasury yields surged sharply on Friday, propelled by the policy-sensitive two-year note, following Federal Reserve Chair Kevin Warsh's remarks that the central bank would consider rate increases if officials were not confident inflation was moving sustainably toward 2%.

Warsh's comments were seen as a clear signal that policymakers could raise rates if inflation remained stubborn, fueling bets of a rate hike next month. Markets now assign a 60% probability to a September rate hike, up from 35% before the commentary. The rise in oil prices further pressured the market, as the benchmark Brent crude surged above $90 a barrel following US forces' strikes on Iran's Larak Island, the first reported strikes inside Iran since late July.

For India, which relies heavily on oil imports, a sustained rise in crude prices could exacerbate inflation concerns and impact government finances. The Reserve Bank of India's August meeting minutes revealed policymakers were prepared to raise interest rates if upside inflation risks emerged. Overnight indexed swap rates (OIS) climbed sharply as traders accounted for the possibility of a Fed rate hike next month, with the one-year swap rate at 6.02% and the two-year rate at 6.22%. The most liquid five-year rate rose 8 basis points to 6.52%.