The rupee snapped a five-day losing streak on Tuesday as custodian banks sold dollars on the back of sharp gains in the domestic share market, but persistent dollar demand from oil refiners to meet month-end requirements capped the gains.
Traders are also hopeful the government would succeed in pushing through key reforms in the winter session, despite the parliament having been adjourned for a fourth day.
Moody's also reiterated that its outlook on India's sovereign rating of Baa3 remains stable, citing the country's high savings and investment rates.
"The way the rupee had been moving for the past few days it appeared that we might have hit 56 today itself, but it received some respite from gains in stocks and the euro," said Paresh Nayar, head of fixed income and forex trading at First Rand Bank.
"There seem to have been good custodian flows today. Demand from oilers was persistent since the last few days. Trade deficit numbers will be crucial now. Market could see a wide and choppy range of 54.30 and 56.20 in the next few days," Nayar added.
The Sensex posted its biggest daily gain in more than two months as investor sentiment turned positive on growing hopes the government would push through reforms to stimulate growth and avoid a ratings downgrade.
The partially convertible rupee closed at 55.45/46 per dollar up 0.5 percent versus its previous close of 55.73/74 on Monday.
Foreign fund flows into and out of the share market have a huge influence on the rupee's fortunes. Foreign funds have bought shares worth more than $19 billion so far in 2012 but the rupee remains down about 4.3 percent.
Traders said oil refiners, the biggest buyers of dollars in the domestic currency market have been buying continuously over the last few days to meet their month-end import commitments, hurting the rupee.
Lack of dollar inflows had also exaggerated the fall due to oil demand, traders said. The central bank is expected to step in and sell dollars to prevent the rupee from slipping below 56, traders said.
Euro's gains versus the dollar also aided the rupee. The euro bounced to a one-month high against the dollar on Tuesday after international lenders agreed a new debt target for Greece, but eased back after a Fed policymaker's comments boosted the U.S. currency.
In the offshore non-deliverable forwards market, the one-month contract was at 55.72 while the three-month was at 56.30.
In the currency futures market, the most-traded near-term dollar/rupee contracts on the National Stock Exchange, the MCX-SX and the United Stock Exchange all closed at around 55.7250 with a total traded volume at around $5.97 billion.