As Union Budget 2026 approaches on February 1, bond markets are seeking reassurance rather than spectacle from fiscal policy. With global rate cycles remaining uneven and India's entry into global bond indices no longer providing immediate catalyst, the Budget has become the primary domestic anchor for yields, term premia, and investor confidence.

Over the past two years, the government has rebuilt trust with fixed-income markets through consistent and credible fiscal policy. Targets were not dramatic, but they were met, helping markets absorb large borrowing programmes without destabilising long-term rates even as global yields rose sharply.

Fiscal Deficit: The Critical Signal

Budget 2026 will test whether fiscal discipline has become embedded in policy framework. The most critical signal will be the fiscal deficit target for FY27. Markets are not demanding austerity or expecting sudden deficit reduction, but are looking for continuity and visible progress towards debt stabilisation.

Any indication that consolidation is being paused, diluted, or postponed will be reflected immediately in the yield curve. Bond investors have grown sensitive to the quality of consolidation, preferring revenue-led improvement, realistic subsidy assumptions, and transparent accounting over cosmetic adjustments and off-balance-sheet manoeuvres.

Borrowing Programme and Supply Management

Beyond the deficit, the borrowing programme will shape market behaviour throughout the year. The size of government borrowing is no longer the sole concern—delivery mechanism matters equally. With domestic institutions expected to absorb the bulk of issuance, predictability becomes a powerful stabiliser.

Effective supply management includes:

• Well-telegraphed auction calendar
• Thoughtful maturity distribution
• Active use of switches and buybacks
• Reduced volatility despite heavy supply

Poorly managed supply does not remain confined to government bonds but spills over into state development loans and high-quality corporate credit, widening spreads and tightening financial conditions unnecessarily.

Capital Expenditure and Execution Focus

Capital expenditure remains a central pillar of the Budget narrative. Public capex has justified higher borrowing by offering growth support without stoking near-term inflation. However, as allocations scale up, bond market focus is shifting from intent to impact.

Capex that translates into output supports growth and improves debt dynamics, while stalled capex simply adds to supply without corresponding benefits.

Financial Market Dynamics

Household financial flows present another influence on bond markets. Administered small savings rates, if misaligned with broader interest rate conditions, can distort deposit mobilisation and alter demand for government securities. Budget policies that respect these linkages help preserve financial stability.

With global index inclusion deferred, incremental improvements in market microstructure take on greater significance. Liquidity, transparency, and ease of participation for long-term investors may not grab headlines, but they reduce friction ultimately reflected in yields.

Market Confidence and Policy Continuity

Budget 2026 is unlikely to be remembered for dramatic announcements. Its importance lies in either reinforcing the trust carefully rebuilt between fiscal policy and bond markets, or testing it. For fixed income investors, this distinction matters enormously—when confidence holds, markets remain patient, but when it cracks, they are not.

Foreign institutional investors (FIIs) have withdrawn $21 billion from Indian markets since the beginning of 2025, prompting equity strategists to look toward the Union Budget as a potential catalyst for reversing this trend. Morgan Stanley's Ridham Desai, who leads the firm's India equity strategy team, has identified three specific capital market reforms that could meaningfully address the FII outflow challenge.

Three Key Reform Areas

Desai outlined the potential reforms in a Budget strategy note, emphasizing their importance in addressing foreign portfolio investor concerns:

"There has been growing concern about the negative balance of payments and foreign portfolio investor (FPI) selling. In this context, it is quite possible that the Budget proposes broadening the base of foreign portfolio investors, allowing more pools of capital to access Indian stocks," Desai stated.

GIFT City Development Strategy

The enhancement of GIFT City represents a significant opportunity for India to compete with established international financial centers. As global financial flows increasingly route through such centers, GIFT City remains underdeveloped compared to peers like Singapore and Hong Kong. By strengthening tax incentives and regulatory frameworks, the government could attract more foreign capital into Indian securities through platforms such as the Gateway International Exchange.

This development would create additional avenues for FII participation, particularly benefiting investors facing regulatory or structural constraints in traditional market-access mechanisms.

Current Market Outflow Situation

The foreign investment landscape presents concerning trends for Indian markets:

Budget Expectations and Market Positioning

Desai's team expects the Budget to focus on several key areas that could support market recovery. "It appears the market is expecting modest fiscal consolidation to protect growth, flat to higher capital spending as a percentage of GDP, and some additional tax incentives for manufacturing," he noted.

The Budget is likely to emphasize deficit reduction, government capital expenditure, the debt calendar, and capital market reforms specifically aimed at boosting foreign inflows. Morgan Stanley maintains an overweight stance on Financials, Consumer Discretionary, and Industrials sectors, which would likely serve as primary beneficiaries if FII flows return.

Historical Budget Performance Analysis

Morgan Stanley's analysis reveals important patterns in market behavior around Budget announcements. India is currently tracking lower on both absolute and relative bases heading into the budget. Historical data shows that when equity markets have fallen in the 30 days preceding the Budget announcement, the probability of a post-budget rally increases meaningfully.

Conversely, the market has historically fallen on two of three occasions in the 30 days following the budget. This probability rises to 75% if the market has risen in the 30 days preceding the budget. Only on three occasions in 32 years has the market been up both before and after the budget, with the most recent occurrence in 2024.

"This year, India is tracking lower on both an absolute and relative basis, and if it were to hold this performance into the budget day, the chances of a post-budget rally increase," the global brokerage concluded.