The rupee fell and bond yields surged after the Reserve Bank of India (RBI) surprised markets with an increase in the repo rate on Friday, putting its focus squarely back on managing inflation and the fiscal deficit.
The RBI provided some reprieve to the bond market by unwinding some of the cash tightening steps undertaken since mid-July.
Still, the surprise 25 basis points increase in the policy rate to 7.50 per cent and the cautious stance on inflation, led to fears that the central bank was not done with raising the repo rate. The bond and interest rate swap curves steepened.
"We actually think the entire policy statement is slightly hawkish given the modestly greater focus on inflation over growth and the central bank's admittance that the WPI inflation is likely to be higher than originally anticipated," said Nizam Idris, a strategist with Macquarie Capital.
Bond yields rose, with the 10-year bond yield closing at the day's high of 8.58 per cent, up 39 bps on the day. The negative spread between the 1-year and 5-year OIS shrunk to 46 bps from 70 bps on Thursday.
The RBI lowered the marginal standing facility rate for banks by 75 basis points to 9.5 per cent and the minimum daily average cash balance that banks need to maintain to 95 per cent from 99 per cent previously.
The cash-tightening steps were initiated by the central bank in mid-July when the rupee began sliding to a series of record lows, to fall to as much as 68.85 to a dollar in late August.
RBI Governor Raghuram Rajan said the RBI would further ease tight cash conditions if the rupee stabilised.
The overnight rate, at which banks lend to each other, fell to 9.25 per cent from 10.25-10.40 per cent levels after the RBI decision.
"It is an honourable exit for the RBI and is the best way Rajan could take a step back towards normalising things. The hike in repo rate gives the message that inflation is still high but he is trying to bring down the MSF corridor," said Manish Wadhawan, head of interest rate trading at HSBC in Mumbai.
"The bond yield curve and the OIS curve is steepening and it will steepen more until the central bank's next policy review in end-November."
The rupee extended losses after the decision, falling as much as 62.61 to a dollar, before suspected central bank intervention helped ease some of the losses. It closed at 62.23/24 to a dollar versus 61.77/78 on Thursday.
Still, it gained 2 per cent during the week reflecting the recent inflows from the RBI's forex swap facilities as well as the Federal Reserve decision to continue with monetary stimulus.
It had fallen as much as 20 per cent to record lows in late August, but has recovered around 9 per cent since Rajan took office on Sept 4.
Sensex extended falls to nearly 3 per cent, with banking stocks leading declines before they retraced some losses to close down 1.85 per cent. The main banking index ended down more than 4 per cent.