The Reserve Bank of India surprised markets by raising the repo rate by 25 basis points to 8.00 percent, a week after a central bank panel had recommended making taming consumer inflation a priority in monetary policy.
Although the move was unexpected, RBI Governor Raghuram Rajan softened its impact by saying he did not foresee further near-term tightening if consumer price inflation eases, according to a central bank statement.
That allowed bond prices to recover after the benchmark 10-year bond yield had risen to as high as 8.84 percent immediately after the decision, a 15 bps increase from the session low.
The yield was last at 8.78 percent, up 1 basis point on the day.
R. Sivakumar, head of fixed income for Axis Mutual Fund called the rate hike "unexpected," but said the markets saw a silver lining.
"What is far more encouraging from the market's perspective is that the RBI has signalled they are probably done with rate hikes, and if inflation moderates more than what they have indicated, they may become more accommodative," Sivakumar said.
"That is basically central bank speak for they may start delivering rate cuts going forward."
The prospect the RBI could be less willing to raise interest rates could support bonds, after benchmark 10-year yields had risen 25 bps in the last five sessions after the recommendations of the central bank's monetary panel.
The outlook for bonds will also depend on foreign investors who have bought a net $2.95 billion in debt so far this month, their second consecutive month of purchases.
The RBI review comes ahead of the Federal Reserve's policy meeting at which the U.S. central bank is expected to continue with its reduction in monthly bond purchases, a possibility which has raised uncertainty in emerging markets.
In the overnight indexed swap market, the benchmark five-year swap rate rose 4 bps to 8.30 percent and the one-year rate was up 6 bps at 8.49 percent from pre-policy levels.