By Swati Bhat
MUMBAI (Reuters) - Government bonds rallied while stocks gained on Wednesday after the Reserve Bank of India (RBI) surprised investors by keeping rates on hold, but it kept the door open to more rate increases should a recent surge in inflation fail to ease.
Financial markets had geared up for a quarter percentage point increase in key rates after record retail price inflation and a 14-month high reading on the wholesale price index. These prompted 39 of 43 respondents in a Reuters poll to predict a 25 bps hike on Wednesday.
The central bank kept talking tough on inflation despite unexpectedly holding its policy interest rate unchanged, saying it would be ready to act even if the country struggled to raise its low growth rate.
The benchmark BSE Sensex and the broader Nifty closed up 1.2 percent and 1.3 percent, respectively.
The benchmark 10-year bond yield fell as much as 15 basis points on the day to 8.76 percent after the policy review. It ended down 13 bps at 8.78 percent.
The partially convertible rupee closely mirrored moves in shares but weakened towards the end of trade. It closed at 62.09/10 per dollar, weaker than its previous close of 62.01/02.
"We see stability at the current level in bonds with buying appetite given lower supplies in coming months," said Shakti Satapathy, a fixed income strategist at AK Capital.
"The onus would now largely be towards the Fed announcement and the core CPI trajectory in the coming months. As both of the above triggers have been discounted in the market, we see a near-term chaos if the Fed announces something beyond expectations," he added.
The benchmark 5-year overnight indexed swap rate closed down 10 bps at 8.40 percent while the 1-year rate ended 12 bps lower at 8.44 percent.
Many analysts were surprised by the RBI decision.
"It is completely unexpected given the liquidity in the system as well as the inflation trajectory," said Rupa Rege Nitsure, chief economist at Bank of Baroda in Mumbai.
"I think it is just postponement of action, because the policy clearly says they may take action any time, even in the interim between two policies, if the situation warrants," she added.
The U.S. Federal Reserve's two-day meeting ends late on Wednesday amid fears globally that the central bank will soon move to cut its monetary stimulus.
Worries about tapering have sparked foreign investor sell-off in Indian markets since they emerged in May, hitting bonds in particular.
(Editing by Richard Borsuk and Robert Birsel)