Finance Minister Arun Jaitley's decision to stick with FY17 fiscal deficit target of 3.5 per cent of GDP has triggered hopes of an out-of-turn interest rate cut by Reserve Bank Governor Raghuram Rajan.
"The necessary condition for a rate cut has been met with fiscal deficit target retained at 3.5 per cent... That is increasing expectations of an inter-meeting rate cut in the market," said Anindya Dasgupta, treasurer at Barclays.
Analysts were confident that the government will meet its FY16 fiscal deficit target of 3.9 per cent of GDP, but there was speculation that Mr Jaitley may relax FY17 deficit target to implement the 7th Pay Commission wage-hike proposal, recapitalize state-run banks and boost rural spending. Concerns that FY17 fiscal deficit target could be raised had led to a selloff in stocks, currency and bond markets.
The relief rally in bond and rupee markets following Mr Jaitley's fiscal deficit announcement was therefore hardly surprising for analysts. The benchmark 10-year bond yield declined 16 basis points to end at 7.62 per cent, its biggest single-day fall since June 8, 2015. The rupee ended at 68.43, posting the biggest rally in three weeks.
"The ongoing supply pressure in the bond market is likely to ease in the near term - as government budgets for lower net borrowing of Rs 4.25 lakh crore in FY17 via dated securities compared to Rs 4.41 lakh crore FY16 (revised estimates)," said Dr DK Pant of India Ratings and Research.
Monday's Budget has also led to the clamour for a bigger rate cut in the coming months.
"Sticking to the fiscal deficit target for the moment as compared to expectations of missing the target is a big positive...We expect RBI to cut rates by further 50 basis points by mid-June," said Siddhartha Sanyal, India economist of Barclays.
The Sensex, which had plunged by 660 points in intraday trade, also made a sharp recovery as clarity emerged on the government's market borrowing. Analysts say the government's gross borrowing from bond markets will be at Rs 6 lakh, in line with the Rs 5.8 lakh crore borrowing in the previous three years.
"The commitment towards staying the fiscal deficit path, which in turn is important for macro stability, and could also give room for RBI rate cut, was acknowledged by the market with the late rise," said Geojit BNP Paribas Financial Services.
The BSE Sensex closed 152 points down at 23,002, while the Nifty ended 43 points lower at 6,987
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