MUMBAI (Reuters) - Indian shares and bonds rallied on Wednesday, sending key indicators to their highest in several years, after the hawkish RBI governor said he had taken note of falling inflation, reinforcing bets about future rate cuts.
Investors had grown confident the Reserve Bank of India would change its hawkish stance and focus on economic growth after wholesale inflation data on Tuesday sharply eased.
Those bets got a further lift from RBI Governor Duvvuri Subbarao who said during a visit to Germany on Tuesday that the fall in inflation would be taken into account for future policy decisions, in what markets interpreted as a shift in stance.
Just over a week ago, the RBI had disappointed investors by sounding cautious on future monetary easing, despite cutting interest rates for a third time this year.
"Inflation has been one of the most important concerns. And with that slowing sharply, particularly falling in RBI's comfort zone, think the room for monetary policy easing has definitely increased sharply," said Rohit Arora, emerging market rate strategist at Barclays Capital in Singapore.
The 10-year bond yield fell 7 basis points to 7.40 percent, after earlier falling as low as 7.35 percent, the lowest since December 2 2009.
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Bond yields have dropped as much as 39 basis points since the RBI's review on May 3. Despite the central bank's hawkish comments at that meeting, investors had anticipated falling inflation would force the central bank's hand.
The Nifty gained 2.4 percent, hitting its highest intraday level since January 2011 in trade. The rally was led by lenders such as ICICI Bank. The Sensex was up more than 450 points at 2:16 p.m.
Gains in stocks and bonds this month have also been aided by a global market rally sparked by easier monetary policy that has led to a surge in foreign investments into domestic markets.
Foreign investors have invested $1.51 billion in debt so far in May, more than the $992.2 million for the whole of April. They have also been net buyers of stocks for 19 consecutive sessions as of Tuesday, according to regulatory data.
The rally is also being aided by expectations the RBI will address a tight liquidity crunch in the banking system by buying bonds.
Still, not all analysts are convinced the RBI will cut interest rates as early as its next review on June 17, since the central bank has already cut India's key lending rate by 75 basis points this year.
India's current account deficit could remain a key hurdle. Just on Monday, stocks had posted their biggest single day percentage fall in about a year after a jump in gold and silver imports caused the April trade deficit to spike.
Subbarao had said earlier that the current account deficit, which hit a record 6.7 percent in the December quarter, would be a factor in monetary policy decisions.
The rupee, which tends to rally at times of foreign inflows, has in fact fallen 1.8 percent against the dollar this month, reflecting some of that caution.
Some analysts also said the divergence between consumer price inflation at 9.39 percent and wholesale price inflation at 4.89 percent in April muddle the interest rate outlook.
Although the RBI has traditionally looked at WPI, the CPI is believed to be growing in importance.
"Clearly the rally was triggered by seemingly less-cautious remarks by the central bank on inflation overnight, said Radhika Rao, an economist with DBS Bank.
"We are sceptical on whether the rally has legs, especially in light of the RBI commentary at the recent review and the 70 percent jump in the trade deficit."
(Reporting by Rafael Nam and Archana Narayanan; Additional reporting by Abhishek Vishnoi and Swati Bhat; Editing by Jacqueline Wong)