By Subhadip Sircar
MUMBAI (Reuters) - Government bonds rose on Monday, tailing gains in the rupee, but a sharp rise in inflation dented sentiment ahead of the RBI's policy review later this week.
Yields rose sharply after data showed that headline inflation in August rose to a six-month high, further complicating policy making for the new central bank governor Raghuram Rajan.
Food inflation accelerated to a three-year high of 18.18 percent in August, government data released on Monday showed, driving the benchmark Wholesale Price Index up by a stronger-than-expected 6.1 percent.
The re-emergence of inflation muddies waters for the central bank trying to stabilise a falling currency as well as supporting economic growth which has slipped to its lowest in a decade.
"It is difficult to predict the monetary policy stance because there is a new governor. However, from a rate perspective, I think it will be a non-event. The big caveat is however the FOMC meeting," said Killol Pandya, senior fund manager-debt, at LIC Nomura Mutual Fund.
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Still, bonds managed to hold on to early gains in line with assets in other emerging markets after Lawrence Summers, perceived as relatively hawkish by markets, withdrew from the race for the next Federal Reserve chief.
The 10-year bond yield closed down 6 basis point at 8.43 percent. It rose to 8.54 percent after the inflation numbers. Yields had dropped 14 basis points last week.
With the bond market veering around to the view that RBI was unlikely to act on policy rates, the focus will be on whether the central banks partly or wholly reverses its cash tightening steps undertaken since mid-July to stabilise the rupee.
The overnight cash rate shot past the Marginal Standing Facility rate of 10.25 percent on Monday to a near six-month high as the banking system continued to feel the strain from the withdrawal of funds by corporates for payment of advance tax.
The RBI had to hold a special emergency auction on Saturday at its 10.25 percent rate to meet the demand for funds from lenders after the collateralised borrowing and lending obligation, or CBLO, rate shot past 70 percent.
In the overnight indexed swap market, the benchmark five-year rate closed flat at 8.35 percent, while the one-year rate ended down 1 basis point at 9.19 percent.
(Editing by Anand Basu)