China bond yields up

China's bond yields mostly rose on Tuesday after central bank chief Zhou Xiaochuan said that although monetary authorities would aid reconstruction after this month's earthquake, policy must continue to fight inflation.
Traders interpreted Zhou's remarks as indicating the central bank expected only a very short-term blow to economic growth from the quake, and that it worried reconstruction work could actually end up boosting growth excessively in the long run.
Zhou appeared to be signalling that the central bank remained ready to hike interest rates at least once in coming months if inflation did not come back down, several traders said. "The central bank may hike interest rates in the second half after the recovery from the earthquake. Banks are selling long-term bonds fairly aggressively today," said a trader at an Asian bank in Shanghai.
Visiting the city of Chongqing, near the disaster zone, Zhou said on Monday that the central bank would focus at present on aiding reconstruction. But he also called for a "forward-looking" policy that took into account long-term economic development.
"We must meet enterprises' demands for relief and reconstruction work, and also implement effectively economic tightening steps to prevent excessive growth of inflation and investment," Zhou said in comments. While uncertainty about the global growth outlook means the central bank will not rush to hike rates aggressively, it may now believe it overreacted to economic damage from last winter's fierce snowstorms, some traders said.
The central bank engineered a major, undeclared easing of money market liquidity in January through March, and has been scrambling since then to absorb some of that money via steps such as this month's reserve ratio hike. So Zhou's comments on Monday may have amounted to a pledge not to repeat the mistake.
And while the impact of the quake on inflation remains unclear, the quake has increased uncertainty about the inflation trend, which may steepen the bond curve in coming months.
ING Bank said in a research note on Tuesday that consumer price inflation, at 8.5 percent in April, might eventually hit double digits because authorities still viewed the inflation problem largely as a supply shock, and were therefore ordering oil companies and power generating firms to increase production.
"The stubbornness of the inflation shock and their view that it's all supply shocks have left the authorities behind the curve on inflation. The risk is that inflation hits double digits before the supply response kicks in," ING said.
China Merchants Bank said in a research note on Monday that the central bank would keep policy tight in the medium term in order to curb inflation, because it understood that despite economic losses from the quake, reconstruction would ultimately boost growth.
"In a moderately tight liquidity environment, government bonds and financial bonds may experience consolidation for the short term," China Merchants said. The indicative five-year government bond yield edged up to an eight-week high of 3.8882 percent bid on Tuesday from 3.8873 percent on Monday, while the seven-year yield rose faster, to a 10-week high of 4.0555 percent from 4.0468 percent, according to Reuters Reference Rates.
BILL YIELDS MIXED In the money market, bill yields were narrowly mixed because three small equity offers, which take subscriptions through early next week, partly offset improving availability of funds from big banks. The weighted average seven-day repo rate eased to 3.4080 percent by midday from 3.4776 percent on Monday.
Traders believe the repo may fall near 3.0 percent in the next week or so because of heavy inflows from foreign exchange reserves. The reserves surged by a monthly record of $74.46 billion in April to $1.75666 trillion, a source familiar with the data told Reuters.
But the repo may not go much below 3.0 percent since major banks, keen to boost their excess reserve ratios after some ratios fell to multi-year lows in April, will be cautious about lending in coming months, traders said. "The central bank does not want liquidity to return to previous ample conditions. So the seven-day repo may stay above 3.0 percent," said a trader at a US bank in Shanghai. The 90-day central bank bill yield rose to 3.5250 percent bid on Tuesday from 3.5210 percent, but the one-year yield eased to 4.0950 percent from 4.0962 percent.