How China Interest Rates will affect Markets

China's central bank raised interest rates on Christmas Day, moving sooner than many analysts and market participants had expected to ramp up its campaign to combat inflation.

Many observers had thought the People's Bank of China (PBOC) might hold off in raising rates for a second time since mid-October until at least the new year, especially after Chinese money market rates spiked last week, meaning many investors will have been taken off guard by the latest step.

How will Chinese shares react?

Broadly, a 25 basis point move is too small to spark a sustained, sharp selloff. While a knee-jerk move lower in Shanghai at Monday's open is possible, optimism for Chinese shares in 2011 is likely to encourage investors to "buy the dip" and send Shanghai markets higher even on the day. That may send Hong Kong's market, closed on Monday, higher on Tuesday.

Sectors most at risk of a leg down are commodity-related firms, which have outperformed this quarter as commodity and energy prices have rallied into the year-end.

The sub-index of energy shares in Hong Kong is up 11.1% this quarter. The CSI Energy Index of shares listed on the mainland is up 22.5%. Surging gold, silver and copper prices have boosted shares of mining companies. That trade is likely to see some unwinding.

The impact on Chinese banking shares, the most heavily weighted sector on the Shanghai and Hong Kong markets, is likely to be neutral in the near term. Rising interest rates are seen benefitting banks' net interest margins but uncertainty over new lending quotas and further tightening will likely cap gains.

On the charts, the Shanghai Composite as well as the Hang Seng indexes are looking a little weak in the near-term. The Shanghai Composite closed below its 250-day moving average on Friday, while the Hang Seng is forming a topping "head and shoulders" pattern on the daily as well as weekly charts.

What about other Asian equities?

Asian markets will lead the reaction to the latest rate rise from China. Japan's Nikkei will be the first major Asian index to open along with Korea's KOSPI.

While the Nikkei could open weaker, that is unlikely to disturb the steady rise seen over the past seven weeks. It has in fact outperformed the rest of Asia since China's rate increase in October. The Nikkei is up about 10% since then versus a 2.7% rise for the MSCI Asia ex-Japan.

Southeast Asian stocks are likely to see some of their stellar annual gains trimmed. Indonesian and Thai markets are among the world's top performers this year as foreign investors pumped money into emerging markets, particularly in Asia.

The last Chinese rate increase in October came after Chinese markets had closed for the day. The move prompted a bit of a slump in Europe and the United States, with markets unsure how Chinese investors would react. The Shanghai Composite opened higher the following day, helping to stabilise other markets. This time, Chinese markets will likely lead the reaction: a measured reaction in China would set the tone for the rest of the markets.

Will China's rate rise hurt commodities?

Commodity markets in China will likely see a sharp negative correction on Monday, with a chance some could test recently expanded downside limits. The opportunity to cash in on prices at or near their highest in years before the year end could mean the correction this time may be greater than the losses following the last interest rate rise in October.

That sent the dollar higher, dragged gold down by more than 2%, oil fell 4%, copper lost almost 2.5%, while wheat fell 2.7% and corn 2%.

But analysts said it did not spell the end of the commodities rally, as corrections in markets, including copper, corn and soy -- key imports for China -- would be viewed as buying opportunities.

How big will the reaction be in G10 currencies?

Reduced trading volumes because of holidays in major financial centres will limit the reaction in G10 currency markets and make price action whippy.

The biggest reaction may be in the Australian dollar because of the big trade ties between China and Australia and the market's use of the Aussie as a proxy for the Chinese economy. The rate increase could catch traders off guard and lead to profit taking on bets on the Aussie.

The Aussie has gained the most against the dollar in December among G10 peers, up 4.8% to USD 1.0053, benefitting from a late-year comeback in risk taking. It has also in the last few weeks become an even more popular play against the euro, rising nearly 4% to AU$1.3035 per euro.

Aussie/U.S. dollar has hit a higher daily low for the past six trading days - so a move below Friday's USD 1.0018 low would suggest the upward trend is losing momentum.

How will yuan NDFs react?

The rate rise may be a catalyst for further downward pressure on dollar/yuan non-deliverable forwards. The most liquid one-year tenor , which finished trading on Friday at 6.50, may see the biggest decline in coming days.

The combination of two interest rate rises and three bank reserve requirement increases in the last two months suggests Beijing is focused squarely on inflation and may indeed use the yuan to help fight imported inflation from rising oil and other commodity prices, allowing it to rise more in coming months.

That could set the NDF market up for a moderate correction.

The one-year NDF implied expectations the yuan would appreciate as much as 4.3% against the dollar in late October, before a series of weaker mid-point fixings triggered early year-end profit taking, bringing implied appreciation in a year's time to 2.1%.