By Swati Bhat
MUMBAI (Reuters) - India's debt and swap markets rallied on Tuesday as the Reserve Bank of India (RBI) reinforced expectations of an interest rate cut early next year.
The RBI held interest rates steady at a policy review earlier in the day, as widely expected, but said it could ease monetary policy by early 2015 depending on whether inflation cools further and on government efforts to shore up the country's finances.
Indian markets initially extended losses in a knee-jerk reaction to the RBI's decision to maintain status quo on rates, but soon recovered as traders bet on monetary easing at the RBI's next review on February 3.
The benchmark 10-year bond yield, which rose 3 basis points (bps) in the immediate aftermath of the policy review, closed down 9 bps at 7.97 percent, after touching 7.95 percent intraday, its lowest level since July 19, 2013.
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Traders said they expect the debt and swap market rally to continue in the near-term, though the pace of the rally may slow until there is more clarity on the timing of the rate move.
"The bond market is running ahead, but there's more conviction about policy easing by February," said A. Prasanna, economist with ICICI Securities Primary Dealership in Mumbai.
Banking stocks also rallied on rate cut bets while state-run banks gained on hopes of large treasury gains due to the fall in bond yields.
The NSE Bank index closed 0.16 percent higher after dropping as much as 1.2 percent earlier.
In the overnight indexed swap market, the benchmark 5-year swap rate dropped to a low of 7.05 percent, its lowest since June 19, 2013 while the 1-year swap rate fell as low as 7.67 percent, its lowest since July 15, 2013.
The 5-year rate ended down 6 bps on the day at 7.10 percent while the 1-year rate closed steady on the day at 7.75 percent. Rates rose on profit-booking in the latter part of the session, traders said.
"OIS is pricing in cuts, but that doesn't mean we can't go any lower as everything depends on how fast the RBI cuts rates, which in turn depends on how inflation pans out. I wouldn't pay rates here but bonds definitely offer value," said Kumar Rachapudi, a fixed income strategist with ANZ Bank in Singapore.
"The 10-year bond yield can move to 7.50 percent once the RBI starts cutting."
(Reporting by Swati Bhat; Editing by Kim Coghill and Biju Dwarakanath)
