6 Min Read
* IRS jump implies no expectations of further rate cuts
* IRS based on short-term rates increasingly pessimistic
* Repo-based money management made cuts unnecessary - traders
* Economy shows signs of recovery, but risks remain - economist
By Lu Jianxin and Pete Sweeney
SHANGHAI, Nov 29 (Reuters) - China's money market has abandoned hope that Beijing will cut interest rates in the near future, as signs of economic recovery have convinced players to stop betting on cheaper money in the pipeline.
"Growth recovery was the last straw that broke market expectations of another rate cut," said an IRS trader at a major Chinese bank in Shanghai.
The People's Bank of China (PBOC) cut interest rates twice in June and July and lowered bank's reserve requirement ratios (RRR) three times since late 2011, freeing an estimated 1.2 trillion yuan ($192.70 billion) for new lending.
But traders and economists, with an eye on the queasy state of global trade, predicted that the central bank would be compelled to make further cuts, and this sentiment was clearly reflected in China's interest rate swap (IRS) market, which prices market's expectations for the future price of money.
Monetary easing expectations put downward pressure on short-term and long-term IRS contracts, as the market looked forward to a series of upcoming cuts aimed at offsetting the effects of the slowdown in Europe.
IRS hit their lowest level since the global financial crisis in mid-July, but rates have steadily recovered since then.
In the past two weeks rates jumped, showing that not only have investors given up on the prospect of cuts in the near term, they have little confidence that there will be more cuts in 2013.
"If the PBOC is reluctant to cut RRR to boost economic growth, how can it cut interest rates?" said the Shanghai IRS trader.
IRS with a float based on the PBOC's benchmark one-year yuan deposit rate are the most explicit indicators of policy rate expectations.
Over the past two weeks, two-year IRS based on this long-term rate have mostly been quoted above 2.75 percent, compared with 2.7225 on Nov. 12, when Beijing released better-than-expected economic data, and with 2.394 in late July.
Because China's one-year policy rate stands at 3.0 percent at present, and because the PBOC typically cuts rates in increments of 25 basis points, the float of the two-year IRS suggests the market has doubts that Beijing will cut rates again before 2014.
In late July, the same contracts implied that traders expected at least two more cuts, on top of the two already enacted, within the next 12 months.
"Deposit rate-based IRS now imply that the previously widely expected cycle of interest rate cuts has wound down," said an IRS trader at an Asian bank.
"This is partly an outcome of the PBOC's insistence on keeping reverse repo rates stable since the last rate cut in early July."
The trader was referring to the PBOC's newfound affection for short-term reverse repos as a tool to guide rate expectations, similar to the way the U.S. Federal Reserve influences money rates.
The PBOC has held the official rate of its seven-day reverse repo contract steady between 3.30-3.40 percent since early July, when the rate was fixed at 3.80-3.95 percent, indicating that it has no intention of allowing short-term funding costs to decline further.
IRS based on China's most actively traded money market rate, the seven-day repo rate, have been gradually trading increasingly higher than policy rate-based IRS since late July, implying that the market is more pessimistic over short-term funding costs.
Two-year IRS that refer to the seven-day repo rate were quoted at 3.4 percent at midday on Thursday, their highest level since October last year.
While IRS based on the seven-day repo rate do not directly imply policy rate expectations, their mid-July level suggested the market expected four PBOC rate cuts within 12 months, traders said.
China's economic managers have justified their decision to hold off on further rate cuts by referring to fears that inflation will return.
Officials have repeatedly noted the need to balance the economy's need for liquidity against the risk that cheap money will reinflate real estate asset bubbles and push up food prices.
The benchmark one-year deposit rate had been negative against China's CPI for more than two years until April.
"Authorities probably also don't want to discourage savers by pushing the real interest rate into negative territory so quickly after it has turned positive for just a few months," said a trader at a Chinese state-owned bank in Beijing.
Some economists still believe the PBOC should cut rates, if for no other reason than to improve sentiment.
Domestic equities markets are still underperforming, and while some key indicators such as exports are showing signs of recovery, debt overhangs at local governments and state enterprises remain a source of concern.
"I'm not convinced of the recovery story," said Chia Woon Khien, managing director at the Royal Bank of Scotland.
"I think all sorts of things can still be cut."