By Swati Bhat
MUMBAI (Reuters) - Indian markets rallied on Thursday after the Reserve Bank of India (RBI) surprised with a 25-basis-point rate cut and hinted at more amid easing inflation and the government's fiscal consolidation efforts.
Although markets had been widely pricing in Reserve Bank of India (RBI) rate cuts, most investors had expected the central bank to start easing either at its next scheduled policy review on Feb. 3 or sometime after the government unveiled its annual budget at the end of February.
Instead, traders were caught off guard as the RBI cut its repo interest rate by 25 bps to 7.75 percent.
"This should be taken as a vote of confidence on falling inflation and the government's efforts," said Samir Arora, founder and fund manager at Helios Capital in Singapore.
Arora said he now expected at least 100 basis points in rate cuts over the next year as policymakers look to boost sluggish economic growth.
The benchmark 10-year bond yield fell to 7.65 percent, down 12 bps on the day and its lowest level since July 2013.
Stocks rallied, with the Nifty gaining more than 2.5 percent and the NSE Bank index climbing as much as 4.3 percent to a record high.
The rupee partially convertible rupee gained to as much as 61.47, its strongest level since Nov. 13.
Still, traders said the size and scope of the government's upcoming budget will be a key factor in determining whether bonds rally further.
Efforts to contain the fiscal deficit, if accompanied by continued cooling in inflation, could spark a further rally in debt markets, according to analysts.
Morgan Stanley predicted the RBI could potentially cut rates by a further 125 bps over the next 12 months, including a possible 25 bps rate cut on Feb. 3.
"We believe that this is a beginning of a big rate cut cycle," said Morgan Stanley in a report on Thursday.
"Our rate cut forecast is predicated on our view that CPI inflation will stay at closer to 5 percent of the calendar year 2015, as the reduction in fiscal deficit, sustained deceleration in rural wages and lower global commodity prices will mean that inflationary pressures in the economy will be contained."
The one-year rate was pricing in the prospect of an additional 75 bps in rate cuts over the next year.
(Additional reporting by Abhishek Vishnoi; Editing by Simon Cameron-Moore & Kim Coghill)