Chinese Selloff Intensifies As Traders Expect Imminent Rate Hike Following China State Council Comments

In a surprising reversal, the Shanghai Composite has dropped 3% in early trading following a statement by the China State Council which on Monday said it will revise penalties to crack down on price violations to tackle inflation, which has been interpreted by traders as an imminent December rate hike. Per Dow Jones: "Shanghai Composite Index down 2.5%3.0% at 2793.95, faces immediate support at 2750 level. "There has been heightened expectations for an interest rate hike soon, which exacerbated earlier weakness in the index from sovereign debt concerns from Europe as well as a stronger U.S. dollar," says Wang Junqing, analyst from Guosen Securities." More importantly key stat arb pairs such as the AUDJPY and the ESZ/NDZ are being dragged below the surface. On an indexed basis, the ES will soon take out the intraday lows per the AUDJPY. For Brian Sack's sake, we hope the Fed has its midnight crew in tow as this could get ugly fast. We will be following.

Elsewhere a former PBoC head published comments calling for faster cooling, and for the government to begin fighting runaway inflation. One of the mechanisms proposed is CNY reval. Of course, with all the pressure from DC on the CNY, China is far more likely to hike the deposit rate before it actually is seen as acceding to Schumer's demands (to wit: Tuesday CNYUSD fixing at 6.6762 compared to 6.6700 on Monday).

From Market News:

China should shift back to a prudent monetary policy stance to fight inflation because rising prices have become the key threat to the economy, a former People's Bank of China branch head said in comments published Tuesday.

Sheng Songcheng, who was formerly director of the central bank branch in Shenyang, in China's northeast, said that there is more room for the PBOC to raise the reserve requirement, and that deposit interest rates should be increased in order to tame inflation.

Consumer price inflation, which hit a 25-month high of 4.4% y/y in October, is likely to have hit a fresh multi-year high this month, Sheng warned in the Financial News.

"The government should officially announce a shift to a prudent monetary policy to manage inflation expectations...the normalization of monetary and credit conditions is actually a return to prudent monetary policy," Sheng wrote in the newspaper, which is published by the PBOC.

China has raised the reserve requirement five times and interest rates once this year.

A shift away from the "appropriately loose" monetary policy stance of the last two years is expected to be unveiled in the coming weeks. The government ran a prudent monetary policy stance from 1999 until 2006, when resurgent price pressures forced a shift towards a tightening bias.

Sheng noted Chinese household savings fell by CNY686.5 bln in October because of a widening negative interest rate and that money is flowing into the stock market, property sector and even consumer goods, fueling inflation and asset bubbles.

"Allowing deposit rate to float up will help to correct negative interest rate and curb inflation," Sheng said.

Gradual and modest yuan appreciation is also still the best choice for exchange rate reform as it gives Chinese exporters time to adjust and also eases imported inflation pressure, Sheng said

Finally, Reuters China, citing, China International Capital Corporation, had this to say (whoever has a better translation please chime in):

"We expect between now and 2011 will likely raise interest rates twice by 25 basis points, due to short-term inflationary pressures are likely to exceed expectations, we believe that the end of this year and early next year, months before the rate hike has increased."

But do not think gold will increase the interest rate increase, but the point rate hike may be ahead. As the second half of next year, CPI inflation down, which will reduce the pressure to raise interest rates.

The investment bank also said that if inflation rose sharply than expected appreciation of the renminbi will become more important than the interest rate tightening tool may accelerate the pace of appreciation. Expected effective exchange rate of RMB to the next 12 months increased by 5%. Due to appreciation of the renminbi would help commodity imports in the relief brought by imported inflation.

h/t London Dude