Banking liquidity remains in surplus : Banking liquidity surplus improved more than anticipated, primarily driven by robust month-end government spending. Looking ahead, we expect liquidity surplus to strengthen further, supported by continued government expenditure. Additionally, the upcoming CRR rate cuts will provide further relief, helping to counterbalance the seasonal rise in currency in circulation. These factors collectively point to a more accommodative liquidity environment in the near term.

Inflation falls further : Headline inflation further fell to 1.55% in July from 2.1% in June, led by a faster than expected moderation in food prices especially vegetables. Overall food CPI could record mild positive growth in August after remaining in deflation for two months in a row, while core CPI remains largely range-bound. As the favourable base effect dissipates, we expect headline CPI to inch up. The IMD's forecast of an above-normal monsoon is likely to support the crop harvests, which, in addition to the healthy buffer stocks, is likely to ensure that food prices remain benign. Crude oil prices fell 6.1% over the month amid reduced demand and increased oil supply.

GST rationalization to boost domestic consumption : The government announced a major overhaul of the GST framework, introducing a simplified two-slab system aimed at making essential goods more affordable, reducing tax-related disputes, and boosting domestic consumption. Notably, this reform follows the Rs 1 trillion in income tax incentives unveiled in Budget 2025-marking a direct policy push to accelerate India's consumption-driven growth cycle. The key test is whether this fiscal push, reinforced by monetary easing and a good monsoon, can finally unlock India's muted consumption cycle. The government will transition from the current four-tier GST system (5%, 12%, 18%, 28%) to a streamlined two-slab structure - 5% merit rate and 18% standard rate. This has been explained in detail in the equity market review and outlook.

GDP data comes in stronger : India's real GDP growth surged to 7.8% in Q1FY26 (up from 7.4% in Q4FY25, largely due to a significantly lower GDP deflator of 0.9% compared to 3.1% in the previous quarter. This came on the back of nominal GDP growth slowing to 8.8% from 10.8%. The growth was broad-based, with gross fixed capital formation (GFCF) rising 7.8%, private consumption growing 7.0%, and government consumption rebounding sharply by 7.4%, aided by a low base in Q1FY25 due to election-related spending slowdown. The tariff related headwinds could be offset by GST rationalization.

S&P Global upgrades India's Rating : After 18 years, S&P Global Ratings has upgraded India's long-term unsolicited sovereign credit rating from 'BBB-' to 'BBB', and its short-term rating from 'A-3' to 'A-2'. The upgrade reflects confidence in India's strong economic growth trajectory, improved monetary policy credibility, and sustained fiscal consolidation. The outlook on the long-term rating remains stable. Importantly, S&P noted that the impact of U.S. tariffs on India is expected to be manageable, given the country's limited reliance on external trade and the dominant role of domestic demand in driving its economy. While the upgrade is unlikely to have an immediate positive impact on the rupee due to lingering tariff-related uncertainties, it significantly enhances India's relative attractiveness as an investment destination. Over the medium term, the rating improvement is expected to lower India's cost of capital and bolster investor confidence in the country's macroeconomic stability and reform momentum.

Rupee depreciates in July : While the US Dollar remained largely range-bound through August-with the DXY slipping just 0.2%, the Rupee came under pressure, depreciating by 0.7% against the dollar. This made our currency one of the weakest performers in the region.

The depreciation was primarily driven by lingering uncertainty around tariffs, which weighed on investor sentiment.

US treasury yields fall : The yields on US Treasuries fell towards the end of the month after the Fed chair signaled that interest rate cuts could be on the horizon in light of deteriorating financial conditions. He also said that the central bank was moving "carefully" when it comes to monetary policy.

Market view

There were quite a few variables at play in the domestic markets, nervousness about tariffs, the S&P upgraded, GST rationalization and strong GDP growth. The rating upgrade by S&P has been backed by buoyant economic growth, commitment to fiscal consolidation, improved quality of spending (capex at 3.1% of GDP), anchored inflation expectations amid policy continuity. However, while this improves the investment climate for India, a rating upgrade does not necessarily impact bond markets to quite an extent.

In our Acumen - "Unlocking tactical opportunities in a dislocated bond market", we have highlighted that the recent sell-off has caused a dislocation in the bond market, where shortterm bonds have outperformed long-term ones. However, this has also created tactical opportunities for informed investors. The sell-off has pushed bond yields, particularly for government bonds, back to levels seen before the recent rate-cut cycle began. This offers a more attractive entry point for investors. There's a possibility of a 15-25 bps rally in long duration bonds in the near term. This could be triggered by several factors, including:

• Growth headwinds: Any additional tariffs or economic developments that weaken India's growth outlook could prompt the RBI to deploy additional policy tools, such as a rate cut, to stimulate the economy.
• Global Shifts in Monetary policy: A dovish stance by the US Federal Reserve driven by unemployment concerns could lead to rate cuts, thus supporting global and Indian bond yields.
• RBI Intervention: To stabilize yields and mitigate market volatility, the RBI may consider conducting targeted Open Market Operations (OMOs) in limited quantities. Additionally, in response to prevailing demand-supply mismatches, the central bank could recalibrate the upcoming auction calendar for October 2025 to March 2026 by reducing the proportion of long-duration bond issuances within the overall borrowing program.

Meanwhile, in the US, the Fed has indicated a rate cut on the horizon and this supports our view of two rate cuts in 2025. Indicators such as a softening labor market and tariff-related growth headwinds support this view. The cumulative easing could total 75-100 basis points, especially if trade tensions persist and fiscal policy remains tight.

Risks to our view: The risks to our view at this point are as below
1) Currency
2) Growth shocks globally and in India
3) Inclusion in Bloomberg indices

Strategy - We have gradually reduced duration in our portfolios since February 2025 transitioning from long duration strategies to accrual-based strategies.

We believe that the current year's demand-supply mismatch is worsening, with limited tactical support and rising issuance. This imbalance could increase pressure on yields, especially in long-duration segments.

We have been adding 2-5 year corporate bonds to the portfolio as we expect surplus banking liquidity, lower supply of corporate bonds/ CDs due to slowdown and delay in implementation of LCR guidelines and attractive spreads and valuations. Incrementally short bonds can outperform long bonds from risk-reward perspective due to a shallow rate cut cycle, lower OMO purchases in the second half of the year and a shift in focus to Govt Debt to GDP targets.

What should investors do?
• In line with our core macro view, we continue to advise short- to medium-term funds with tactical allocation of gilt funds to our clients.

Source: Bloomberg, Axis MF Research.