* C.bank to keep money market liquidity loose for now
* But little further room for short-term yields to drop
* Economic recovery talk pushes up long end of curve
* One-/15-year yield spread hits new high
* C.bank may allow flexible loan rates, not ease further
By Karen Yeung
SHANGHAI, March 6 (Reuters) - China's yield curve steepened further on Friday on signs that the economy was heading towards an early recovery while authorities would keep money market liquidity loose to facilitate debt sales.
The central bank is set to conduct a surprise net injection of 41 billion yuan ($6 billion) into the money market this week after a combined net drain of 262.5 billion yuan in the previous two weeks.
Traders think this shows that while the central bank does not want liquidity to loosen further, it also does not want any tightening that could interfere with large government bond issuance to fund its fiscal stimulus programme in coming months.
That pushed the weighted average seven-day bond repurchase rate CN7DRP=CFXS down to 0.9354 percent by midday from 0.9521 percent on Thursday. The indicative 90-day central bank bill yield CN3MNFIX=R slipped to 1.0850 percent bid from 1.0930 percent, Reuters Reference Rates showed.
But at the same time, officials are sounding increasingly confident about an economic recovery, which suggests there may be no more cuts in official interest rates.
Central bank governor Zhou Xiaochuan said on Friday that China saw signs of its economy recovering. Late on Thursday, deputy central bank governor Su Ning said: "We expect China's economy can see a substantial recovery in the second half of this year." [ID:nSP395515] [ID:nL5207739]
And Premier Wen Jiabao estimated on Thursday that inflation would be around 4 percent in 2009. Many analysts think that is unrealistic -- consumer prices rose just 1.0 percent in January, and may well have dropped in February -- but it did indicate authorities saw a possibility of inflationary pressure increasing considerably in the second half of this year. [ID:nPEK92955]
That makes further interest rate cuts even less likely. The rate outlook, and expectations for heavy government bond supply in the second half of 2009, helped push the five-year government bond yield CN5YTFIX=R up to a two-week high of 2.4330 percent bid on Friday from 2.4249 percent on Thursday.
EXIM BANK BONDS
Loose money market liquidity pushed short-term bond yields down. Export-Import Bank of China sold 10 billion yuan of three-year bonds at a yield of 1.78 percent, at the low end of forecasts, with a healthy bid-to-cover ratio of 1.98 times.
Thet pushed down the indicative secondary market yield for three-year financial bonds issued by policy banks CN3YSFIX=R to 1.9100 percent bid from 1.9140 percent.
But traders increasingly see little downside for yields.
"There's not much room for central government and policy bank bond yields to fall further. Banks are keen to divert money into higher-yielding investments such as local government bond issues," said a trader at a mid-sized bank in Shanghai.
Local governments will be permitted to issue 200 billion yuan of bonds this year, some of which are expected to carry high yields because of greater credit risk. [ID:nSHA312807]
A sign that central government bond yields have generally bottomed is a narrowing spread to corporate bonds, as hopes for economic recovery encourage some funds to flow back to corporate debt from government debt.
The spread of the five-year AAA rated corporate bond AAACND5YFIX= shrank to 139 bps on Friday from 143 bps on Thursday and 184 bps in early January.
Although bill yields dropped on Friday, trade was thin bcause the market does not expect any large fall from current levels, traders said. The central bank is believed to want the seven-day repo to move in a range of about 0.90 to 1.05 percent in coming months, which would put a floor under bill yields.
"Bill yields are likely to stabilise in coming days. The market expects an economic recovery, so it thinks the central bank is not likely to ease liquidity policy further," said a trader at a securities company in Shanghai.
A stabilisation of bill yields could help to slow the spectacular steepening of the bond curve.
The spread between the one-year CN1YTFIX=R and 15-year government bond yields CN15YTFIX=R widened to a multi-year high of 268 basis points on Friday, far higher than its previous peak in recent years of 186 bps, hit in May 2007.
A clue to the central bank's monetary policy intentions came on Friday when Zhou said the central bank was considering whether to give commercial banks more flexibility to cut their corporate loan rates.
The central bank will "enhance the capacity and expertise of financial institutions in risk pricing and give a greater role to the market in determining interest rates", Zhou said.
Under current rules, banks must charge at least 90 percent of the benchmark rates set by the central bank for different tenors; the central bank will now "explore the possibility of lowering the lending rate floor." [ID:nPEK174786] By achieving lower bank loan rates through increased competition between commercial banks, the central bank may now be aiming to stimulate the economy while avoiding any further cuts in its benchmark lending and deposit rates, or any further reduction in banks' funding costs.
Following are yields based on Reuters Reference Rates (bid):
CHINA YIELD CURVE (pct)
March 6 Pvs Day Change 7-day repo CN7DRP=CFXS 0.9354 0.9521 -1.67 bps 7-day SHIBOR SHICNYSWD= 0.9275 0.9421 -1.46 bps 90-day CB bill CN3MNFIX=R 1.0850 1.0930 -0.80 bps 1-year CB bill CN1YNFIX=R 1.1966 1.2046 -0.80 bps 5-year Tsy CN5YTFIX=R 2.4330 2.4249 +0.81 bps 15-year Tsy CN15YTFIX=R 3.7435 3.7255 +1.80 bps Note: Repo rate is weighted average.
To see SHIBOR rates, please click SHIBOR=
For information on reference rates for central bank bills, treasury bonds and sovereign bonds, please click CNFIXINDEX.
To see a general guide to contributed price data, news and analysis, please click <CN/CONT1>. ($1 = 6.83 yuan) (Editing by Andrew Torchia)