MUMBAI (Reuters) - The unexpected change in the Reserve Bank of India's monetary policy stance to "neutral" from "accommodative" could spell an end to a rally in the country's long-tenor bonds, although the rupee could be supported if interest rates remain on hold.
Benchmark 10-year bond yields rose 9 basis points to 6.84 percent on Thursday.
The RBI's surprise made yields soar, leaving them 32 basis points higher on Wednesday - their biggest one-day rise since September 2013, when the central bank jolted markets by unexpectedly raising interest rates amid a currency crisis.
While bond prices kept falling on Thursday, the rupee rose in early trade to reach 66.9575, its strongest level since Nov. 10, and at 0838 GMT, was trading at 67.00/01 per dollar versus its previous close of 67.19/20.
The diverging moves came after India's central bank kept its policy rate on hold and signalled an end to its longest easing cycle since the global financial crisis. The RBI said inflation poses a bigger threat to the economy than a crackdown on "black money".
Holding interest rates will disappoint companies and executives, though a surplus of cash in the banking system has kept short-term interest rates low.
Wednesday's hold will likely improve India's appeal for foreign investors at a time of flows from emerging markets to the United States as the Federal Reserve gears up to raise interest rates.
With the RBI's surprising stance change, "there is no chance of any more rate cuts now, especially with the U.S. Fed expected to hike rates," said Ashtosh Raina, head of foreign exchange trading at HDFC Bank.
Bonds had experienced a powerful rally, with 10-year yields down nearly 125 bps through Tuesday, after the RBI in January 2015 began an easing cycle that brought 175 bps in cuts.
But the appeal of long-end debt will be reduced, with investors seen shifting to shorter-term bonds at a time when the liquidity in the system is expected to be comfortable after a surge in deposits of high-value banknotes banned by the government late last year.
Investors thus see both the bond yield and interest rate swap curves steepening in the medium term.
"Given the change in policy stance, the attractiveness of long duration gilt and income funds seems to have reduced in the near term," said Dhaval Kapadia, director and portfolio strategist at Morningstar Investment Adviser India.
"Short-term income funds with good credit quality portfolios can be considered for additional investments," he said.
The shift in the RBI's accommodative stance could also support the rupee, which hit a record low of 68.8650 on Nov. 24, as the dollar was rallying.
India's repo rate remains at 6.25 percent, still among the highest in emerging Asia, and that could help attract inflows into the debt market.
But whether the rupee can find support also depends on shares. The currency has traditionally tracked equities closely, given the larger foreign investor base and as the rupee also reflects bets on the economic outlook.
HDFC's Raina said he expected the rupee find support around 66.50 per dollar in the near term.
Reporting by Swati Bhat; Editing by Richard Borsuk