MONEY MARKETS-Asian swaps fall in step with US ahead of Fed

* Interest rate swaps in Asia fall, caution ahead of Fed

* Korean swaps fall but market prepares for exit strategy

* India's cash bonds plan also targets excess cash with banks

By Vidya Ranganathan

SINGAPORE, Aug 12 (Reuters) - Interest rate swaps in Malaysia, Singapore and other Asian markets fell on Wednesday, in conjunction with a rally in dollar rates markets as investors scaled back pricing of how aggressive the Fed is likely to be.

The Federal Reserve ends a two-day policy review on Wednesday. Consensus expectations are for the near-zero rates to be left on hold and for the Fed to reiterate its commitment to loose policy.

To some extent, investors are also braced for the possibility that the Fed may announce it is not extending a $300 billion Treasury buying programme that is due to expire in September.

Yet, the growing view that market participants may have been too aggressive in pricing in the Fed's likely tightening after last Friday's jobs report has caused rates to rally this week.

Not just that, investors seemed to be wary of betting too heavily on the Fed painting a very rosy picture for the U.S. economy, particularly after the Bank of England shocked markets by expanding its quantitative easing programme last week.

Eurodollar futures have rallied, with the December contract EDZ9 now pricing 3-month LIBOR at 0.675 percent, rather than an aggressive 0.8 percent on Friday.

"The movement over the past two days is in line with our thinking, but not nearly sufficient yet," analysts at Brown Brothers Harriman said in a note.

"The risk is that there has to be further unwinding of Fed tightening expectations. The market then remains vulnerable to the event risk posed by the FOMC meeting."

One-year dollar interest rate swaps USDIRS have fallen 13 basis points to 0.797 percent since Friday. Moving in tandem with that, Singapore dollar one-year IRS SGDIRS has fallen 20 basis points since Tuesday to 0.86 percent, while Malaysian one-year IRS dropped 3 basis points to 2.29 percent.

Even in South Korea, where investors are struggling with the Bank of Korea's mixed messages on Tuesday, the one-year swap has fallen 16 basis points since Friday to 3.14 percent.

ASIA'S EXIT STRATEGY

Korean swaps and bond yields fell initially after the BOK said on Tuesday that the bond market may have over-reacted to a brightening economic outlook.

Yet, the central bank's upbeat assessment of economic recovery and confirmation that its exit strategy had begun, at least based on its withdrawal of dollar funding for domestic banks, had most analysts predicting the central bank will raise rates early next year.

The won KRW= hit a 3-week high against the dollar while one-year bond yields were 2 basis points higher than Tuesday at 2.98 percent.

This week, India's government also said it will start selling cash management bills, with tenors under 91 days, for the first time to help tide over its short-term funding mismatches.

While that appeared mainly to be a mechanism to allow the government to borrow cheaply from the market, it is also a new way for the central bank to manage volatile cash conditions in the money market.

Money supply in the Indian banking system is expanding at 20 percent, above a central bank target of 18 percent for the current fiscal year, and banks have close to $24 billion in surplus funds parked with the central bank.

China too has been slowly absorbing excess funds from its money market through bond issues. Just a few weeks back, it resumed issuing one-year bills through weekly auctions, and yields on such auctions have been creeping up.

"Our view is that while historically Asian central banks have followed the Fed in setting monetary policy, in the absence of banking crises in their respective countries, a comparatively strong recovery will convince most central banks in Asia to move ahead of the Fed," said Sameer Goel, senior Asian rates strategist at Deutsche Bank.

Analysts at Standard Chartered Bank said Bank of Korea's statement and its open discussion of an exit strategy conveyed its confidence about the economic recovery and that would limit further rallies in the bond market. They forecast Korean rates will rise 100 basis points in 2010.

"Given the sharp sell-off in recent weeks, we expect short covering to emerge near-term and see scope for yields to ease back down between now and the end of Q3 2009," analysts Danny Suwanapruti and Suktae Oh said in a note.

"Thereafter, we are bearish on the won rates market over the medium term and expect bond yields to rise by around 40-70 bps by the end of second quarter 2010, while IRS rates should rise by 70-80 bps."

(Editing by Tomasz Janowski)