MUMBAI (Reuters) - Indian government bonds rallied on Monday, sending benchmark yields to a 29-month low, after a slower-than-expected rise in headline inflation cemented hopes the central bank will cut rates by at least 25 basis points later this month.
The 1-year overnight index swap (OIS) rate, which is most sensitive to near-term rates cuts, fell to a seven-month low after the December wholesale price index (WPI) rose 7.18 percent from a year ago, according to data on Monday.
That was below expectations of a 7.4 percent rise, and marked a three-year low.
Some analysts say the Reserve Bank of India could even deliver a rate cut of 50 basis points (bps) at its policy review on January 29, especially after core inflation eased to 4.2 percent last month from around 4.5 percent in November.
"The moderation in core inflation is encouraging and makes a case for higher rate cut in the forthcoming policy meet," said Shakti Satapathy, a fixed income analyst with AK Capital, referring to a 50 bps cut.
"Having said that, the comfortable yield levels and lesser threat of a high-interest scenario in the coming days might push the central bank into taking a conservative rate cut of 25 bps in a staggered manner over the next two policy meets."
Nomura, in a report after the data release, said it expects 50 bps of rate cuts in the first half of 2013, but rising headline inflation in the second half will limit room for rate cuts.
Dealers also said the government's move to delay by two years implementation of controversial rules on tax avoidance to 2016 was also likely to soothe foreign investors.
The benchmark 10-year bond yield ended down 7 basis point at 7.80 percent. It fell to 7.79 percent in trade, its lowest since August 9, 2010.
Yields have eased as much as 35 basis points in a rally that started on December 21, 2012 on the back of hopes for interest rate cuts, as well as increasing confidence in the government's resolve to contain its fiscal deficit.
India has scheduled only one weekly bond issuance this month and recently announced an increase in railway passenger fares, while the federal cabinet is soon expected to consider a hike in diesel prices.
Bond strategists said the 1-month rate swap was pricing in a 70 bps probability of a half-a-percentage point cut.
The 1-year rate fell 5 bps to 7.48 percent, its lowest since June 14, 2012. The benchmark 5-year OIS rate was down 6 bps at 7.12 percent.
The negative spread between the two rates has narrowed to 36 bps from 48 bps at the end of 2012, largely driven by the fall in the short-end on rate cut expectations.
(Reporting by Subhadip Sircar; Editing by Rafael Nam)