Chinese investors went from relief to apprehension of more tightening ahead on Monday after the central bank's surprise Christmas Day interest rate rise, pushing the stock market down 1.9 percent after earlier gains. The 25-basis-point increase in benchmark lending and deposit rates by the People's Bank of China (PBOC) came somewhat earlier than many investors had expected, suggesting authorities may be front-loading their tightening measures and triggering speculation that yuan strength may be employed to fight price pressures.
Stock market punters initially piled into sectors seen as potentially benefiting from higher interest rates, including banks and insurers, but those bets reversed in the last hour of trade, while offshore yuan forwards reflected expectations for greater appreciation in coming months.
The benchmark Shanghai Composite Index ended up closing at 2,781.4 points, easily below the 250-day moving average, a closely watched technical level in the Chinese market. "There was intense stir-frying in the morning," said Chen Shaodan, an analyst at China Development Bank Securities in Beijing, using a Chinese phrase to describe speculation.
"But the market did not show an increase in turnover in the morning rally, so together with weak sentiment amid concern over further tightening, there was little else to be expected other than a reversal of the trend in the afternoon."
The yuan fell slightly in the spot market, but non-deliverable forwards moved to imply more appreciation in three months and a year's time. One-year dollar-yuan non-deliverable forwards (NDFs) fell to 6.4750 bid on Monday from Friday's close of 6.500, with implied yuan appreciation in a year's time rising to 2.4 percent from 2.0 percent shown on Friday.
Three-month NDFs edged down to 6.5890 bid from Friday's close of 6.6010. Mid-sized banks and property firms, among investors' favourite policy outlook plays, led the zig-zagging trade. China Everbright Bank, the most active stock of the day, closed down 3.7 percent after rising 2.5 percent at one point in the day. Property firm China Vanke dropped 2.9 percent, after having risen 1.7 percent in the early afternoon.
Despite the overall fall in the market, some companies rose on relief that prices for metals such as copper did not fall too sharply on the rate hike. Jiangxi Copper, the country's top copper producer, rose 1.1 percent on the day. Many economists viewed the latest rate rise - the second in just over two months and following a number of increases in banks' required reserves - as a positive for the economy and corporate results in the long term as it could help keep inflation from getting out of hand.
Still, analysts said that the jury was still out on the stock market's direction in the medium term, as tighter monetary policy could bite into companies' margins. "The market dropped more than we expected, with the only reason being that the market is short of liquidity toward year-end," said Lu Yi, managing director of hedge fund Shanghai Qide Investment.
"The mid-term outlook of the market is not optimistic, as China faces the risk of stagflation - characterised by high inflation and stagnant economic growth," Lu said. Investors will also be watching closely for signs of whether the PBOC appears set to let the yuan strengthen more quickly in the coming months as another weapon in the fight against inflation, which hit a 28-month high of 5.1 percent in November.
The yuan fell slightly against the dollar, closing at 6.6308 per dollar, compared with Friday's close of 6.6270. However, some analysts took the fact that the central bank set the day's mid-point higher than last Friday, at 6.6305 per dollar, as a sign that the PBOC could be ready to tolerate further appreciation after letting it strengthen by 0.9 percent against the dollar over the past week. While NDFs imply appreciation of 2.4 percent in a year's time, many forex dealers in the onshore market think it could gain significantly more than that.
"Letting the yuan rise right after a monetary tightening step is a rare phenomenon, as the government typically hopes to curb speculation of yuan appreciation right after such a step," said a senior trader at a major Asian bank in Shanghai. "The government appears thus to be giving a signal that it will use both interest rates and the exchange rate to fight against inflation, including imported inflation."
Domestic bond yields rose slightly, given the market had already priced in a number of interest rate rises over the coming year in the wake of the first rate rise in October. The benchmark five-year government bond yield rose 5 basis point to 3.60 percent, while that for the 10-year tenor rose 9 bp to 3.90 percent.