Mumbai, July 7: The markets showed divergent trends ahead of the Union budget tomorrow with shares ending with a modest gain and the rupee rallying 20 paise against the dollar, even as bond prices ended in the red on worries over rising interest rates.

However, a mood of cautious optimism prevailed with the belief that finance minister P. Chidambaram will continue with reform measures and encourage foreign investment.

Share prices rallied with the BSE sensex ending with a modest gain of over 27 points at 4955.97. Most of the metal stocks appreciated on hopes that Chinese demand is set to improve from its current level. Most of these stocks had rallied yesterday after the freight rates were left untouched in the railway budget.

The bond markets saw government security prices shedding over 30 paise due to concerns over the prospects of a rise in interest rates as indicated by the economic survey. Interest rates, which are now at over 30-year lows, could inch up due to high fiscal deficit and rising credit demand from the commercial sector, the survey said.

“Though the market mood was initially bullish over the survey’s view on the economic growth, the sentiment turned negative with growing concerns about the fiscal deficit and rising interest rates. Bond prices then shed 30-35 paise,” a treasury chief from a leading private sector bank said.

Yields on the benchmark 10-year bond rose to 5.74 per cent from 5.69 per cent yesterday, with the stock ending sharply lower at Rs 112.15/20 from Rs 112.40/42.

According to analysts, the markets are eagerly awaiting the Union budget where they would be looking at the government’s borrowing programme and the steps taken by finance minister P. Chidambaram to improve foreign investment.

The bond markets are also eager to see how Chidambaram tides over coalition politics and drafts revenue generation plans.

“If the finance minister outlines a government borrowing programme of Rs 10,000 crore over that of last year, it would be a major negative,” an analyst added.

In the forex markets, the rupee today rallied against the US dollar, recovering most of its overnight losses due to healthy inflows and the greenback’s weakness overseas. Yet the mood was one of cautious optimism with few players believing that the finance minister would continue with measures to increase foreign investments into the country.

The rupee’s appreciation against the dollar came even as the Economic Survey advocated a flexible exchange rate policy with the ability to intervene as and when necessary.

It also pointed out that the exchange rate policy should look at curbing a sharp appreciation of the Indian currency to make exports more competitive.

The rupee closed at 45.86 per dollar, up 20 paise from Tuesday’s close of Rs 46.04.