The Reserve Bank of India's latest liquidity-tightening measures have sent government bond yields to their highest level in three years. The yield on the benchmark 6.94% 2036 bond rose to 7.3707% as the central bank announced a Rs 25,000 crore bond sale and mandated banks to maintain 99% of their daily cash reserve requirement from October 16. These actions directly drain surplus funds from the banking system, curbing lenders' capacity to invest in government securities and weakening bond demand.
Higher bond yields increase the cost of capital across the economy and shrink the yield gap that has supported equity valuations. The spread between India's 10-year bond yield and the US Treasury yield has narrowed to 205 basis points, near a 22-year low. This has weakened the relative-return case for Indian assets for foreign portfolio investors, who have withdrawn Rs 44,166 crore from equities in October alone and over Rs 3 lakh crore so far in 2026.
Domestic institutions absorb the selling
While foreign institutional investors exit, domestic institutional investors have provided a cushion. DIIs bought a net Rs 3,045 crore of equities on October 12, and equity mutual funds attracted a five-month high inflow of Rs 38,307 crore in September. This domestic buying has prevented a steeper market decline but has not offset the sentiment drag from rising yields and FII outflows.
The pressure from bond yields lands most directly on rate-sensitive sectors and highly valued stocks. On Monday, IT, FMCG, and financial stocks led the market decline as the Nifty fell 157 points. For portfolio managers, the RBI's hawkish stance and the resulting yield shift mean the tactical case for equity inflows remains weak until the bond market stabilizes or the yield gap widens again.