Indian swap rates dropped sharply on Tuesday after the central bank gave cautious comments about the pace of tightening policy after delivering an expected quarter-point rate hike, suggesting it will hold off from being aggressive to smooth over heavy government bond issuance.

The Reserve Bank of India called for a "calibrated" pace of monetary tightening in boosting its reverse repo rate, the floor for money market rates, to 3.75 percent following a surprise inter-meeting move last month.

The remarks prompted market players to reverse positions betting for more aggressive rate hikes and convinced dealers the RBI would keep ample funds in the banking system to help the government's record-sized bond issuance in coming months.

Overnight indexed swap rates fell as much as 20 basis points at the short-end, partly as market players expressed relief that the RBI did not take more aggressive steps to drain liquidity or lift rates a half-point, as some had feared.

The RBI may deliver another inter-meeting increase in rates, but such a move would depend on inflation -- already running at nearly a double-digit pace -- worsening further.

RBI Governor Duvvuri Subbarao said after the meeting that he was not ruling out an inter-meeting policy move.

For now, bond investors breathed a sigh of relief on the RBI's caution.

Ten-year government bond yields dropped 9 basis points in the broad relief rally across markets, but traders said the heavy calendar of bond sales in coming months meant the yield curve was bound to stay steep or steepen further.

The government is scheduled to borrow a record 4.57 trillion rupees ($102 billion) in the current fiscal year that began in April, with 2.87 trillion rupees planned in the first half.

"The pressure on the longer end will be more from the supply side rather than any RBI signal, so that's what will keep the pressure on the yield curve," said Ananth Narayan G, managing director and head of rates at Credit-South Asia.

The one-year OIS dropped 13 basis points to 4.96 percent, poised for its biggest one-day drop in a year and down from a four-month peak hit last week. The benchmark five-year OIS fell 5 basis points to 6.92 percent.

The spread between the one-year and five-year swap widened to 196 basis points, indicating the market saw less risk of the RBI being aggressive on tightening liquidity and hiking rates.

The benchmark 10-year bond yield was at 8.01 percent, down 7 basis points from Monday's closing and off a 1- year high reached earlier in the month.

Call money rates were steady at 3.5 percent, and traders see them hovering near the reverse repo rate -- which would be another sign the RBI is keeping the banking system flush with funds.

RUPEE AND BANK SHARES GAIN

The partially convertible rupee strengthened as far as 44.5075 per dollar, a gain of 0.5 percent on the day and back near a 19-month high struck earlier in the month.

The rupee has jumped about 4 percent this year as foreign investors have poured funds into the stock market.

Bank shares, the most sensitive to RBI policy changes, jumped 1.5 percent and outperformed the 0.3 percent rise in the benchmark SENSEX index.

Bank shares have also beaten the broader market so far this year, rising 6.5 percent compared with a flat reading for the SENSEX.

"The stock market does not appear negative for the moment because investors are seeing stability," said Deven Choksey, managing director at KR Choksey Shares and Securities in Mumbai.

In its policy review, the RBI said excessive capital inflows pose a challenge for exchange rate and monetary management, and analysts said they see a boost in the rupee in the longer term.

"This RBI action is definitely positive for the rupee, because of the widening interest rate differential. We actually see the rupee topping 42 to the dollar by the end of the year," said Joseph Tan, economist at Credit Suisse in Singapore.