HONG KONG, June 21 (Reuters) - Chinese interest rate swaps fell on Monday after Beijing said it would allow more flexibility in its yuan currency, sparking hopes there will be less urgency to tighten monetary policy by raising interest rates.
The spot yuan CNY=CFXS climbed on Monday to its highest versus the dollar since its revaluation five years ago, with the Chinese central bank tolerating broad gains after ditching the currency's two-year peg to the dollar over the weekend.
There had been growing fears China would take more aggressive steps to keep its economy from overheating and to avoid bubbles being formed in asset markets like stocks and property after it pumped a massive amount of cash into its economy last year during the global downturn.
Although Beijing has raised banks' reserve requirements three times this year, it has so far refrained from increasing interest rates and has instead announced clampdowns in the property market and warned banks about their lending policy.
After the announcement on the currency expectations of rate hikes are less, said a Shanghai-based head of trading at a foreign bank, while adding that most of the receiving was in the 2- and 3-year segments.
The 2-year non-deliverable interest rate swaps CNNDIRS2Y=TRHK fell 7 basis points to 2.61 percent while the two year onshore IRS CNYQB3S2Y= eased 8 bps to 2.83 percent.
Worries about rate hikes have heightened recently after inflation quickened to a 19-month high, although moderating factory output and fears of a slowdown as a result of the European debt crisis have offset some of these concerns.
Given the anti-inflation effects of a CNY move, markets could be betting on a less hawkish PBOC in terms of monetary policy, said Frances Cheung, strategist with Credit Agricole CIB.
But it all depends on how quick they will let CNY move, I think it will be very gradual only - their statement is very mild.
The People's Bank of China set Monday's mid-point for the yuan against the dollar CNY=SAEC unchanged at 6.8275 before trading started. The market had expected the mid-point to rise 5 to 10 pips.
We dont see any strong movements from here (in IRS) until the market sees a clear picture on the currency. If the fixing continues to be stable, more paying interest in the rates market will be seen in the future, said the trader in Shanghai.
In the dollar funding market, borrowing costs fell with the three-month dollar rates in Singapore SIUSD3MD=ABSG easing to 0.54067 percent from 0.54083 percent last Friday.
U.S. two-year swap spreads USD2YTS=TWEB, which widen during times of financial stress, were marginally higher at 33.75 bps, still hovering around the month-lows struck last week. They are now well off a one-year peak of 64 basis points set late last month.
Market fears about the debt crisis in Europe have eased somewhat in recent sessions, and there are hopes that the European Union's stress tests on its 25 biggest banks would reassure investors about the health of the continent's financial system. (Reporting by Umesh Desai; Editing by Kim Coghill)