Surprise China MLF rate rise weighs on bonds; yuan and money rates fall

SHANGHAI, Jan 25 (Reuters) - China’s surprise increase in interest rates on medium-term loans weighed on bond prices on Wednesday, while the yuan weakened after the central bank set a weaker daily fixing in response to a rebound in the U.S. dollar overnight.

Money market rates fell as traders focused instead on further cash injections by the central bank as it tries to ease liquidity worries heading into the long Lunar New Year holiday starting on Friday.

But some traders were clearly rattled by China’s first-ever increase in interest rates for its medium-term lending facility (MLF) loans, which was seen as signalling that shorter-term funding costs will move higher eventually as authorities try to cool an explosive increase in debt.

The People’s Bank of China (PBOC) on Tuesday raised the interest rate for one-year and six-month tenors of medium-term lending facility (MLF) loans by 10 basis points each to 3.1 percent and 2.95 percent, respectively.

It also lent 245.5 billion yuan ($36 billion) via MLFs on the same day, in an apparent move to reassure markets it would keep liquidity ample.

It was the PBOC’s first increase in the MLF interest rate since its debuted the liquidity tool in 2014, and first time it has raised one of its policy interest rates since July 2011.

The last time the PBOC adjusted interest rates on MLF loans was in February 2016, when it lowered them.

One trader at a Chinese bank in Shanghai reckoned the rate increase was “bad news” because it raised the cost of funding at a time of seasonally tight liquidity heading into the week-long New Year holiday.

“The MLF loans meet market demand for funds, but the cost is going higher... The central bank is still aiming to reduce leverage at financial institutions,” she said.

Economists at ANZ said the PBOC will likely maintain generally supportive liquidity conditions, but at higher rates as it looks to prevent potential financial risks. Earlier on Tuesday, some Chinese media had reported credit growth could surge again in January, after higher-than-expected bank lending growth in December.

“With MLF rates moving higher, the market may view this as a signal that either the PBOC wants to have a steeper curve, or a higher curve across the tenors,” ANZ said in a note after the rise increase.

The MLF rate move, while very modest, hammered bond futures prices. China’s benchmark 10-year treasury futures for June delivery fell nearly 1 percent.

Yields on 10-year treasury bonds rose 2.4 basis point (bps) to 3.340 percent.

But the benchmark seven-day repo traded in the interbank market dipped 15 bps to 2.4871 percent as the latest in a series of PBOC cash injections eased fears of a cash crunch that had flared up last week. The volume-weighted average rate is considered the best indicator of general liquidity in China.

In currency markets, the PBOC set the yuan midpoint rate at 6.8596 per dollar prior to the market open, weaker than the previous fix of 6.8331.

The weakness followed a rebound in the U.S. dollar overnight after several days of losses in the wake of President Donald Trump’s inaugural speech.

In the spot market, the yuan opened at 6.8652 per dollar and was changing hands at 6.8758 as of 0241 GMT, 173 pips weaker than the previous late session close and 0.24 percent softer than the midpoint.

Traders noted that activity was rapidly thinning ahead of the holiday, with the daily trading volume shrinking to $5.38 billion as of 0250 GMT.

($1 = 6.8780 Chinese yuan renminbi)

Reporting by Winni Zhou and John Ruwitch; Editing by Kim Coghill