Indian bonds see biggest fall in two months; rupee gains on RBI

MUMBAI (Reuters) - Indian bond yields on Thursday saw their biggest spike in two months, while the rupee hit a 20-month high against the dollar, after the central bank kept its policy rate on hold and said it was preparing to drain liquidity from the banking system.

The Reserve Bank of India left the repo rate at 6.25 percent as widely expected, in line with other Asian central banks that have held rates this month.

But the RBI raised the reverse repo rate - or what banks get for deposits at the RBI - by 25 basis points to 6.00 percent. The move should reduce volatility in money market rates which track the difference between those two rates, as well as encourage banks to park their funds with RBI.

That could be a precursor to drain liquidity, with the RBI saying it could undertake measures including additional treasury bill sales, or outright bond sales via open market operations.

Those steps would come at a time when cash in the banking system has soared to around 4 trillion rupees ($61.59 billion), after the government removed higher-value bank notes from circulation in November.

"The market was expecting a neutral to dovish stance but the policy was slightly hawkish," said Harish Agarwal, a fixed income trader with First Rand Bank. "The increase in the reverse repo rate and possibility of more open market operations are all together weighing on the market."

The benchmark 10-year bond yield rose 12 basis points to 6.77 percent, its biggest single-day rise since the previous RBI policy on Feb. 8.

The rupee strengthened to 64.50, its strongest level against the dollar in 20 months, from its close of 64.88/89 on Wednesday.

Shares, however, ended flat.

Since the RBI unexpectedly changed its policy stance to "neutral" from "accommodative" on Feb. 8, the 10-year bond yield has risen 34 bps.

But the rupee has surged on expectations on India's stance on interest rates, which is helping attract foreign investments at a time when the U.S. Federal Reserve tightens policy.

India has attracted a net $8.85 billion in foreign investments into debt and equities in March, the highest monthly amount since at least 2002.

Some analysts even say the central bank could move to hike rates.

"Although we expect RBI to remain on hold for some time, there is an increased likelihood that the next rate move, whenever it materialises, will be a rate hike," said Arvind Chari, head of fixed income and alternatives at Quantum Advisors.

(Reporting by Swati Bhat)