(Reuters)
Updated: 2007-06-12 15:01

China's bond yields rose across the curve on Tuesday and most money market rates edged up after May consumer price inflation came in at 3.4 percent, its highest level in more than two years.

The figure had been widely expected by the market, but it still fuelled selling of bonds by reinforcing expectations of an interest rate hike -- or at a minimum, a reserve ratio rise -- in coming days or weeks, and more tightening in coming months.

Food prices, which account for a third of consumer prices, jumped 8.3 percent from a year earlier in May, adding to concern that an uptrend in inflation could continue for some months.

DBS Bank said in a report on Tuesday that if food prices kept rising at their current pace, CPI inflation could soon enter a 3.5-4.0 percent range.

That would leave the tax-adjusted one-year bank deposit rate a percentage point or more below the inflation rate, requiring several more rate hikes just to prevent China's real interest rates from being negative.

Traders therefore believe government bond yields could rise a further 5 to 10 basis points in the next several weeks, with the inflation threat hurting long-term bonds most.

"The bond curve will continue to steepen because food prices may not fall quickly, sustaining high inflation levels for at least a couple more months," said Ying Junhui, analyst at China Merchants Bank.

The indicative five-year government bond yield in the secondary market rose to 3.5936 percent bid, its highest in over two years, from 3.5664 percent on Monday, according to Reuters Reference Rates.

In the money market, traders bought one-year bills, encouraged by the central bank's decision to leave the yield in its one-year bill auction on Tuesday at 3.0928 percent, flat for the third straight week.

Short-term liquidity is ample and May trade surplus data announced on Monday showed money was continuing to pour in to the market. The surplus ballooned to $22.45 billion, above economists' forecasts of $18.8 billion.

"Bill yields should move sideways for the time being because of ample liquidity coming from the trade surplus, and as banks divert money from longer-term bonds," said a trader at an Asian bank in Shanghai.

However, he and other traders said that after the next interest rate hike, the central bank would quickly permit bill yields to jump at auction. After the last rate hike in mid-May, auction yields immediately climbed about 8 to 15 bps.

The weighted average seven-day repo rate edged down to 2.2666 percent by midday from 2.2875 percent on Monday.

But traders said the seven-day repo was likely to gradually rebound to around 3 percent ahead of China COSCO's initial public offer in Shanghai, which could attract several hundred billion yuan in subscriptions. Funds locked up by the offer will be returned on June 20 and 21.

Apart from one-year and one-month bills, central bank bill yields continued edging up on Tuesday, with the 90-day central bank bill yield indicated at 2.8080 percent bid against 2.8020 percent on Monday.