India's benchmark 10-year government bond yield fell to its lowest level in almost four weeks on Tuesday, Nov. 3, as a drop in crude oil prices eased fears that the Reserve Bank of India will have to raise interest rates sharply. The yield on the 6.94% bond due 2036 closed at 7.3012%, down 1 basis point on the day and the lowest since Oct. 9, Reuters reported. It touched 7.2780% in the session before profit-taking trimmed the gains.

For investors across Asia, the move extends the first real relief for Indian debt after a 10-week surge of more than 70 basis points, Reuters reported. The same bond closed at 7.44% on Oct. 28. Since then the yield has dropped about 14 basis points, most of it in the two sessions after it closed at 7.4139% on Friday, Oct. 30.

Oil explains most of the swing. India is the world's third-largest oil importer, and high crude feeds inflation, weakens the rupee and strains the budget. Brent fell more than 7% on Monday, Nov. 2, to US$104.80 a barrel after talks between Iranian and Qatari officials, Reuters reported, down from near US$117 in late October. It recovered to about US$106 on Tuesday after reports of a U.S. strike on Iran's Qeshm Island.

Why Indian Bond Yields Climbed to Three-Year Highs

The rally follows a long slide. Indian government bonds posted nine straight weekly losses through Oct. 16, with the benchmark yield rising more than 62 basis points over that stretch, according to Reuters. On Oct. 12 the 10-year yield jumped 9 basis points to close at 7.3857%, its highest close in three years and its biggest one-day rise in more than six months.

The trigger was the RBI itself. On Oct. 7 the central bank raised its repo rate by 25 basis points to 5.5% from 5.25% and moved its stance from neutral to calibrated tightening, SCC Online reported, then followed with measures to defend the rupee that drained cash from banks, including open-market bond sales. Consumer inflation quickened to 5.54% in September from 4.83% in August, Trading Economics data show.

Heavy borrowing by the central and state governments added supply. New Delhi auctioned INR 330 billion (about US$3.47 billion) of bonds on Oct. 30. Earlier in October the RBI sold INR 250 billion of bonds through an open-market operation and states lined up INR 312 billion of debt sales the same week, according to Reuters.

In mid-October Nomura said it expected more RBI measures against currency speculation, Reuters reported. Traders also worried that the central bank would accept higher yields to keep a wide gap over U.S. rates. That spread reached 227 basis points in the week to Oct. 16, up from 206 basis points a week earlier.

Swap Rates Still Price More RBI Rate Hikes

The derivatives market has cooled but not reversed. One-year overnight index swap rates fell to 6.63% on Tuesday, two-year rates to 6.64% and five-year rates to 6.7275%, Reuters reported. The one-year rate is still more than a full percentage point above the 5.5% repo rate, which means swap pricing still implies further tightening over the coming year.

Those bets had grown in late October. On Oct. 26, markets were pricing close to 125 basis points of RBI increases over 12 months, Trading Economics reported. Elevated oil prices had fueled bets on further rate hikes, Reuters reported on Oct. 29, and higher inflation had already raised bets on a larger December move by mid-October.

The rupee remains under pressure. It closed at 95.22 per dollar on Oct. 28, after touching 94.46 the previous week, Reuters reported. Tight cash in the banking system continues to limit how much debt local lenders can absorb, traders told Reuters.

U.S. Midterms and Crude Set the Next Move

Traders say the domestic story now depends on events abroad. Gopal Tripathi of Jana Small Finance Bank told Reuters the next key level for the 10-year yield is 7.25%, and that the U.S. midterm elections, through their bearing on the U.S.-Iran conflict and on crude, will guide the next move. A private-bank trader told Reuters on Monday that a lasting rally was unlikely before the vote brought more clarity.

The RBI's Monetary Policy Committee meets next on Dec. 2 to 4, the clearest test of whether the late-October bets on aggressive hikes were overdone.