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The Sensex fell about 1 per cent, heading towards its biggest weekly fall of the year as lenders slumped after data showing consumer inflation edged up, raised concerns about interest-rate cuts and sent bond yields surging.
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.
The benchmark BSE Sensex was down 0.98 per cent at 28,645.85 after gaining as much as 0.9 per cent.
The index was heading for a loss of 2.7 per cent this week, the worst since the week ended Dec. 12, 2014.
The broader Nifty was down 1.01 per cent at 8,687.35, on track for a loss of 2.8 per cent in the week. Interest rate-sensitive banking stocks fell, with NSE bank index down 1.3 per cent.
ICICI Bank fell 1.2 per cent and HDFC Bank lost 1.4 per cent. Lenders were also hurt as they are big holders of debt, which fell on Friday after the CPI data.
The benchmark 10-year bond yield by 0738 GMT was trading up 5 basis points at 7.77 per cent, after hitting 7.78 per cent, its highest since Jan. 14, earlier in the day.
Recent outperformers also fell. ITC Ltd, which gained 2.5 per cent in the previous session on reports of cigarette price hike, dropped 1.7 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.
(Reporting by Indulal PM and Abhishek Vishnoi)
