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UPDATE 1-Shanghai rebar falls after China returns from break, but outlook bright

* Rebar hits lowest level since mid-January

* Chinese markets reopen after week-long Lunar New Year holiday

* Dalian iron ore, coking coal cut gains after initial spike (Adds comment, updates prices)

MANILA, Feb 22 (Reuters) - Chinese steel futures dropped nearly 2 percent on Thursday as investors returning from a week-long Lunar New Year holiday sold off the commodity, which at one point touched its weakest level in five weeks.

Construction activity in China may only get into full swing next month with many workers still away, traders said, but the outlook for steel demand was mostly firm.

The most-active rebar on the Shanghai Futures Exchange fell as far as 3,841 yuan ($605) a tonne, its weakest since Jan. 18. The construction steel product closed down 1.7 percent at 3,866 yuan.

“Steel demand should be firmer when construction work resumes but it will not happen very soon,” said a Shanghai-based trader.

“Traditionally, most of the construction workers will stay at their hometown until early March.”

The peak season in China’s construction begins next month and Argonaut Securities analyst Helen Lau said order books at steel plants and traders for February and March were encouraging.

Low steel inventories along with abundant liquidity in China following a substantial increase in new loans last month “will fuel steel demand recovery”, Lau said in a note.

Iron ore on the Dalian Commodity Exchange ended 0.6 percent higher at 538.50 yuan a tonne, but off the day’s peak of 545 yuan, a one-month high.

“I believe there will be some new buying interest for iron ore, especially traders who would be replenishing their stocks,” said the Shanghai trader.

Chinese steel producers are also building their raw material inventories, eager to unleash their mills’ capacity when this winter’s output curbs end next month and hoping for a repeat of last year’s record margins.

Coking coal rose 0.5 percent to close at 1,378 yuan a tonne, after earlier peaking at 1,408.50 yuan, its strongest level since Dec. 4. Coke climbed 2 percent to 2,176 yuan per tonne, having risen intraday to a nearly three-month high of 2,188 yuan.

Iron ore for delivery to China's Qingdao port .IO62-CNO=MB last traded at $78.43 a tonne on Wednesday, staying flat throughout the Lunar New Year break, according to Metal Bulletin. ($1 = 6.3497 Chinese yuan) (Reporting by Manolo Serapio Jr.; Editing by Joseph Radford and Biju Dwarakanath)

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