MUMBAI, July 16 (Reuters) - Indian bond yields fell on Monday, while five-year swap rates dropped to their lowest this year, after lower-than-expected headline inflation raised hopes for a cut in interest rates at the Reserve Bank of India's July 31 policy review.
Bond markets had started pricing in the prospect of monetary easing from last week after India revised its April industrial production to a contraction of 0.9 percent from its previous estimate of 0.1 percent growth.
However, the views of a rate cut were not uniform. India's core inflation in June grew 4.85 percent from a year ago, unchanged from levels in May, putting in doubt some of the expectations of rate cuts.
Weaker-than-expected rainfalls so far in the monsoon season are also raising worries about a hike in food prices, while the government is believed to be keen to implement some longstanding policy reforms such as raising diesel prices.
"I do not expect this number to prompt the RBI to immediately cut rates," said Shubhada Rao, chief economist at Yes Bank in Mumbai.
"The inflation expectation still remains elevated, and the outlook is cautious because of the performance of monsoon, and its impact on food prices, as well as the impending and much awaited hike in fuel prices."
By mid-afternoon, India's benchmark 10-year bond yield had dropped 6 basis points to 8.04 percent from its previous close.
The country's one-year overnight index swap rate dropped 11 bps to 7.49 percent, a level last seen a month ago.
The five-year rate was down 10 bps to 6.87 percent on the session, the lowest so-far this year.
The falls came after India said wholesale price index rose a lower-than-expected 7.25 percent in June from a year earlier, adding to pressure on the central bank to cut interest rates to help revive slowing growth.
The RBI has kept the repo rate on hold since easing by an aggressive 50 basis points at its April review.
Since then, central bank officials have reiterated their concerns about inflationary pressures, including last month when the RBI disappointed markets by keeping the repo rate on hold, while also keeping the cash reserve ratio unchanged.
The cash reserve determines the amount of funds that lenders must keep with the central bank.
However, the fall in headline inflation, combined with the sharp revision of the April output data, does leave open the possibility of a rate cut. Only a week ago bond investors were overwhelmingly expecting the RBI to stay on hold this month.
"The core and headline inflation are seen trending down. So long as the core data remains under 5 percent it provides room for a rate cut. The headline inflation slowing has amplified rate cut probability," said Manish Wadhawan, director and head of interest rates at HSBC India.
The seasonal adjusted average rate (SAAR) quarter over quarter is at 3 percent in June from 8 percent in December reflecting a downward trend in core inflation, said Wadhawan. (Reporting by Archana Narayanan; Editing by Rafael Nam)