(Updates with quotes, details)
MUMBAI, April 25 (Reuters) - Indian bond yields rose, while the rupee and stocks fell after ratings agency Standard & Poor's cut the country's outlook, with traders predicting increased pressure on the central bank to step in to prevent further falls in markets.
Indian markets have already been battered in recent weeks by the same issues spotlighted by S&P: the rupee has recently been hitting three-and-half-month lows, while bond yields are not far from December 2011 highs.
That explained the relatively muted falls on Wednesday, as S&P cited well-flagged market risks such as India's widening current account and fiscal deficits, expectations of a slowdown in reforms, and the weakening economic outlook.
On top of all these challenges, uncertainty about the taxation of foreign investors has most recently raised fears about slowing capital inflows, at a time when India needs the funds to narrow its current account deficit.
Traders said that markets would continue their recent falls unless the Reserve Bank of India steps in with debt purchases or by intervening in the currency markets, though the central bank may not be in a position to act decisively.
"Since S&P was doing an assessment, this was not quite unexpected. This puts the probability of an actual rating cut on the horizon. If that event happens, it will have a big impact on foreign fund flows," said Sandeep Bagla, senior vice president of ICICI Securities Primary Dealership.
"If the RBI supports the market, yields may move to 8.50 percent. Otherwise, they may go up to 8.75 percent in the near term.
S&P officials had a much publicised meeting with Indian finance ministry officials earlier this month, which had sparked speculation about a potential cut in the outlook.
India's 10-year bond yield rose as much as 4 basis points to 8.63 percent just after the move, not far from the levels above 8.70 percent hit in December.
The rupee fell to 52.64 against the dollar from 52.48 before the action, and not too far from the record low of 54.30 hit in December.
Domestic stocks were also hit, with the main BSE index down 0.9 percent.
"The ratings news combined with potential tax changes for foreign investors is a potentially potent mix for INR. A re-visit to the 2011 highs in USD/INR can't be ruled out," said Jonathan Cavenagh, an FX strategist for Westpac in Singapore.
"The RBI can help sway that sentiment but in the current environment it may well struggle to cap gains in the pair."
Whether the central bank can intervene is very much in doubt.
A key risk remains India's acute liquidity shortage, as shown by the surge in repo borrowings from the central bank.
Borrowings from the repo window remain above 1 trillion rupees, way above the central bank's comfort level.
Any dollar sales would just exacerbate that situation, while
the government has a heavy borrowing program of 3.7 trillion rupees via bonds in the fiscal first half, f u rther draining liquidity from markets. (Reporting By Mumbai Markets; Editing by Subhadip Sircar)