The Sensex and Nifty fell over 1.5 per cent as banking stocks slumped after data showing consumer inflation edged up, raising concerns about interest-rate cuts.
The falls marked a sharp retreat from earlier gains of nearly 1 per cent on optimism about the government's reform agenda after Parliament on Thursday passed a bill raising foreign investment limits in the insurance sector.
But sentiment soured eventually, with investors focusing on data released late on Thursday that showed consumer prices edged up more-than-expected by 5.37 per cent in February, marking a third consecutive month of rise.
The Reserve Bank of India cut interest rates last week for the second time in as many months, and analysts had expected the central bank to next ease monetary policy at its policy review in June.
Analysts warned a more cautious approach on rate cuts could deprive markets of catalysts after indices hit record highs early this month.
"We are left with no triggers now. Investors will be looking for the fourth-quarter earnings next month to take a fresh view. However, any fall will bring down valuations to a comfort zone," said Daljeet S Kohli, head of research at IndiaNivesh.
Rajesh Baheti, MD of Crosseas Capital Services, attributed today's selloff to smart money exiting on rally ahead of the fourth-quarter results season. The Q4 results will kick off from next month. Mr Baheti says he expects earnings not to pick up substantially till the third quarter of next fiscal.
Selling pressure was seen across the board with the selloff particularly severe in banking, capital goods and power stocks. These sectoral indices were down over 2 per cent.
Among banking stocks ICICI Bank and Axis Bank slumped over 2.5 per cent while SBI fell over 2 per cent. BHEL, L&T, Cairn India and JSPL were down between 3-4 per cent.
Shares in DLF Ltd gained 6.4 per cent after a tribunal ruled in favour of the property developer, reducing the tenure of a ban from accessing capital markets imposed by the markets regulator last year. (With Reuters Inputs)
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