MUMBAI (Reuters) - Markets gained on Tuesday after the Reserve Bank of India (RBI) cut interest rates by more than expected, though the rally is unlikely to be sustained after it said inflationary risks would limit the scope of further easing.
Traders also expressed disappointment the RBI had not cut the cash reserve ratio, missing what some analysts saw as a direct chance to inject liquidity into a banking system still starved for cash.
That made for a day of mixed feelings. Initial relief about the RBI's 50 basis points cut in the repo rate -- double what markets had expected -- was later paired with uncertainty about how the central bank will follow up on its first rate cut in three years.
"When you look at it objectively, 25 basis points would have been a token. I think rate cut expectation will remain very, very contained and a lot will depend on growth and inflation numbers," said Nirav Dalal, president of debt capital markets at Yes Bank.
"Based on the current and evolving environment, to expect significant rate cuts in the remaining year might not be possible."
Yields in benchmark 10-year bonds fell 11 basis points to 8.34 percent from Monday's close, though they had initially fallen as much as to 8.22 percent, the lowest in over a month.
The reduced expectations for rate cuts could put a floor on yields, especially given the hefty bond sales expected on the back of the government's higher-than-expected borrowing plans of 5.7 trillion rupees for the fiscal 2012/13 year.
Swap rates pulled back from earlier lows, though the OIS curve is expected to gradually steepen and re-invert.
In rates markets, the 1-year swap rate lost 8 basis points to 7.84 percent from Monday's close, while the 5-year rate fell 6 basis points to 7.42 percent.
Liquidity remains a key concern for markets. The RBI on Tuesday raised the limit for the marginal standing facility through which banks can borrow from the central bank by 100 basis points to 2 percent, which should at least provide more room for banks to access funds.
RBI Deputy Governor H.R. Khan said later in the day that the central bank could selectively purchase bonds via open market operations, helping soothe some of the liquidity concerns.
Continued uncertainty about the RBI's future policy comes at a time when India is already facing a number of economic challenges, including slowing growth, a widening current account deficit, and doubts about the government's fiscal stance.
One of these measures of liquidity, the one-day call rate closed at 8.50/8.55 percent, compared to Monday's close of 8.75/8.80 percent, above the new repo rate of 8.00 percent.
Traders said the call rate would likely reflect the aggressive cut in the repo rate by Wednesday.
The rupee was trading at 51.48 to the dollar compared to Monday's close of 51.68.
"In short term, the 50 bps rate cut is supportive for equities and the rupee. But we maintain that the long-term view on the currency remains negative since the macro picture of the economy continues to be a cause of concern," said Gaurav Garg, a strategist at Citigroup in Singapore.
"We could see the rupee touching its last year's low of 54 soon."
Stocks reacted more strongly, as gains in lenders and real estate developers helped the Nifty and Sensex gain 1.2 percent each.
Reporting By Archana Narayanan, Abhishek Vishnoi, Manoj Dharra, and Aditya Phatak; Writing by Rafael Nam; Editing by Subhadip Sircar, Aradhana Aravindan