By Neha Dasgupta and Aastha Agnihotri
MUMBAI (Reuters) - Indian bonds and the rupee rallied on Monday after Finance Minister Arun Jaitley said the government would stick to its fiscal deficit target for 2016/17, raising expectations the Reserve Bank of India (RBI) may cut interest rates before its next policy review in April.
The benchmark 10-year bond yield ended down 16 bps at 7.62 percent, after falling as much as 18 bps intraday, the lowest since Jan. 22. The 10-year benchmark bond yield posted its biggest single-day fall since June 8, 2015.
The rupee also strengthened on hopes the budget would support economic growth and attract more foreign inflows.
Jaitley said he would stick to the government's existing fiscal deficit target of 3.5 percent of gross domestic product starting in April.
Traders said the government's decision could spur the Reserve Bank of India to cut interest rates by 25 basis points before its next scheduled policy review in early April.
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Benchmark 10-year bond yields may further ease by up to 10 basis points if the RBI cuts rates by 25 basis points, traders said.
Television channel CNBC-TV18 reported the RBI may cut rates soon, citing sources.
But shares fell in a volatile session, with the NSE Nifty down 0.6 percent as energy producers such as Oil and Natural Gas Corp slumped after the government imposed a higher-than-expected tax.
"The necessary condition for a rate cut has been met with fiscal deficit target retained at 3.5 percent," said Anindya Dasgupta, treasurer at Barclays in Mumbai.
"That is increasing expectations of an inter-meeting rate cut in the market."
Coming into the budget traders had feared India would widen its deficit target for the next fiscal year to increase spending.
But the government chose to stick to its target and kept its gross borrowing from bond markets at 6 trillion rupees, in line with the 5.8 trillion rupees borrowing in the previous three years.
The Indian rupee ended at 68.4250/68.4350, posting the biggest single-day gain since Feb. 4. It had ended Friday at 68.62/63.
Still, Standard & Poor's and Moody's Investors Service retained their ratings on India, currently at the lowest investment grade.
S&P said India would need to lower its debt to GDP ratio and materially lower its fiscal deficit for a ratings upgrade.
Fitch Ratings said the budget had a number of positive elements subject to substantial uncertainty.
(Additional reporting by Suvashree Choudhury; Editing by Rafael Nam and Biju Dwarakanath)