Yield on the benchmark 10-year bond fell as much as 69 basis points to 8.21 percent as its price rose. It was last trading at 8.28 percent and headed for its biggest single day fall since at least 1998.

Beaten-down bank stocks rallied as the RBI relaxed some bond holding rules for lenders. State Bank of India (SBI.NS) was up 5.2 percent, while ICICI Bank (ICBK.NS) was 3.8 percent up. The Sensex was 1 percent higher.

Bond yields had risen 135 basis points as of Tuesday's close since the RBI first started tightening market cash conditions in mid-July, adopting a strategy of raising short-term rates to keep rupee speculators at bay.

Those measures have failed to help the rupee, down 5.3 percent since the central bank's first steps, but have instead battered bonds, pushing up yields and raising borrowing costs for companies as banks raised lending rates.

"The decision to wade into government bond markets is interesting, and shows the difficulty that India has in calibrating a monetary policy mix aimed at supporting the rupee, but not choking off economic growth," Sacha Tihanyi, senior currency strategist at Scotiabank wrote in a note.

The RBI said late on Tuesday it will buy 80 billion rupees of bonds on Friday and will pare down its cash management bill sales as its target of pushing up the overnight rate to the central bank's emergency funding rate of 10.25 percent had been achieved.

(Agencies)

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