UPDATE 2-Indian bond yields ease on expected RBI move; OMO hopes dim

Last Updated: Tue, Jan 29, 2013 12:00 hrs

* India's 10-yr bond yield ends at 7.85 pct, down 1 bp

* Central bank cuts repo rate, CRR by 25 basis points each

* RBI chief says to be cautious about timing, size of further cuts (Updates with closing prices, RBI chief's comment)

By Rafael Nam and Subhadip Sircar

MUMBAI, Jan 29 (Reuters) - Indian benchmark 10-year bond yields ended marginally lower on Tuesday after the country's central bank cut interest rates by a quarter percentage point as widely expected, with its cautious stance on future policy disappointing investors.

The Reserve Bank of India did surprise investors by cutting the cash reserve ratio, a key liquidity tool, sending overnight index swap rates lower from early session highs, but investors were cool on a move they saw as likely to reduce the central bank's bond purchases via open market operations (OMOs).

India's government bonds have rallied since last month on anticipation the RBI would deliver up to 100 basis points (bps) of rate cuts this year, an outcome now more in doubt after a statement that still reflected concerns over inflation and the government's fiscal stance.

RBI chief Duvvuri Subbarao said the central bank will judiciously use the monetary space available to it in terms of the timing and size of rate cuts.

"In terms of guidance there maybe another 25 basis points cut in the repo rate in March, but the policy is finely balanced. There are upside risks to inflation and it is not a given that a rate cut will happen in March," said A. Prasanna, an economist at ICICI Securities Primary Dealership in Mumbai.

The 10-year benchmark bond yield ended at 7.85 percent, down 1 bp from its Monday close.

It rose to 7.91 percent early in the session after a central bank report on Monday said the government needed to contain its twin deficits to create room for monetary easing, sowing some seeds of doubt about whether the RBI would actually deliver on the rate cut.

Bond yields have dropped 30 bps since Dec. 21 on expectations that easing wholesale price inflation, which fell in December to a three-year low, would spark aggressive interest rate cuts. The RBI last cut interest rates by 50 bps in April 2012.

The central bank made clear on Tuesday that further easing would be contingent on how the government tackles its fiscal and current account deficits, and on the outlook for inflation.

Overnight index swaps (OIS) showed a bigger reaction after the bank cut the cash reserve ratio by 25 bps, or the amount of cash deposits lenders must keep with the RBI.

The 1-year overnight index swap (OIS) rate fell 5 basis points (bps) to 7.54 percent from levels before the decision, but ended higher 1 bp on the day. The 5-year OIS rate fell 3 bps to 7.14 percent from levels before the rate decision. It ended at 7.17 percent, up 3 bps.

The CRR cut is expected to inject 180 billion rupees ($3.34 billion) into the banking system, providing some relief to the cash-strapped banking sector.

Bank borrowings from the central bank have remained at near 1 trillion rupees this month, far above the RBI's comfort level of around 600 billion rupees deficit.

The stress on liquidity - caused largely by the absence of government spending - has kept the OIS curve inverted, meaning the 1-year OIS rate is trading above the 5-year.

The RBI has injected liquidity via OMO bond purchases since it last cut the CRR on Oct. 31, 2012, though analysts doubted whether it will now continue to do so in February. ($1 = 53.9050 Indian rupees) (Editing by Eric Meijer and Prateek Chatterjee)

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