China IRS distorted by tight money; PBOC comes to rescue

SHANGHAI: The curve of China's interest rate swaps inverted on Tuesday morning, repeating a situation seen a few times last week, as traders said an acute liquidity squeeze on the money market distorted IRS pricing.

The People's Bank of China refrained from draining funds from the market via its government bond repurchase agreements in its regular open market operations on Tuesday and sold only a symbolic 1 billion yuan ($155 million) in one-year bills.

Traders widely expected the PBOC to continue injecting money into the market this week after it conducted an unexpected net injection of 19 billion yuan last week to help rescue the market from the immense liquidity squeeze.

"For the past few weeks many banks have fled interest rate products for short-term borrowing and lending business to seek higher returns," said a trader at a Chinese commercial bank.

"Surging IRS and bond yields have sparked large numbers of stop-loss orders. If this situation persists, it will infringe on the health of the market."

The short-term one-year IRS was flat by midday on Tuesday, staying at a very high level of 4.17 percent and surpassed 4.15 percent for benchmark five-year IRS and 4.11 percent for 10-year IRS .

Since launching a new cycle of monetary tightening last October, the PBOC has raised bank reserve requirement ratios by nine times on top of five official interest rate increases.

"The severity of the money market's squeeze now appears to be even beyond the expectations of the central bank, forcing it to come to the market's rescue as well," said a senior trader at a major Chinese state-owned bank in Beijing.

China's money market rates slipped on Tuesday morning but remained high as demand to meet month-end regulatory requirements, including loan-to-deposit ratios, kept the liquidity squeeze lingering.

With the benchmark seven-day repo rate standing firmly above 5 percent, compared with short-term fundraising cost of around 3 percent considered acceptable by market standards, dealers expected the PBOC not to raise RRR in July for the first month since last November.

The seven-day repo rate slipped to 5.0163 percent by midday from 5.2741 percent at Monday's close.

The shortest overnight repo rate fell to 4.6415 percent from 5.1555 percent while the 14-day repo rate dropped to 6.1694 percent from 6.3904 percent.

All these rates were at very high levels and reflected the severity of the market's current squeeze, traders said.

Copyright Reuters, 2011