By Karen Yeung

SHANGHAI, July 2 (Reuters) - China's bill curve looks set to flatten in coming months after steepening since late last year, as a consensus emerges that any economic recovery will be gradual and central bank policy will focus on quantitative moves.

In fact, just this week, the central bank has signalled that a period of easy money is over as it allowed short-term interest rates higher for the first time in over a year although analysts do not expect any change in policy rates for some time.

The spread between the three-month central bank bill yield and the three-year bill yield ballooned from nearly zero late last year to a peak of 79 basis points in mid-April and has fluctuated near that level since.

The steepening happened when expectations mounted that the economy was bottoming out and deflation would be temporary, ending the 'deflation bill trade' late last year when panicky investors had scrambled to buy low-risk government debt.

But the economic recovery now appears likely to be a drawn-out, gradual affair with gently rising consumer prices and limited monetary tightening.

The spread, last at 77 bps, now looks set to flatten.

'Shorter-end bill yields are likely to rise more quickly in coming months because of tighter liquidity but the longer end is likely to rise more slowly, since the market doubts interest rates will be hiked,' said Bank of China analyst Shi Lei.

A trader at a U.S. bank in Shanghai was more adamant: 'Longer-term bill yields may stabilise while short-term yields rise, as liquidity concerns exceed inflation concerns, and this will narrow the three-month and three-year bill spread by 20 bps in the months ahead.'

INFLATION

The market expects a massive rise in new lending in China, global monetary easing, and the global oil and commodity price surges to revive consumer price inflation around the fourth quarter. Consumer prices fell 1.4 percent in May from a year earlier.

But with employment depressed and spare output capacity plentiful, any price rises will be slow to work their way through the economy.

Shi forecast consumer price inflation would be confined to a well-behaved 2 percent rate through the first half of 2010, forestalling the need for any policy moves as aggressive as an interest rate hike.

China's preference for quantitative steps was apparent in last year's easing.

It axed credit quotas and halted one- and three-year bill issues in its open-market operations but was stingy with rate cuts. It has left the one-year lending rate at 5.31 percent since December 2008 even as consumer and producer prices pressures eased.

'The central bank is expected to start making tiny adjustments in fund drains and auction yields in its open market operations and shift to major tightening steps via credit controls or resumption in one-year bills at the end of the year,' said Xing Ziqiang, analyst at China International Capital Corp.

But the central bank will avoid raising interest rates for the foreseeable future, he said.

As recently as last Thursday the central bank insisted it would stick to an appropriately easy monetary policy to support an economy still lacking a solid footing.

It accordingly injected a generous net 103 billion yuan in June and 189 billion yuan in May in its open market operations.

But this week the bank telegraphed to the money market that it thinks short-term funding rates and bill yields are too low, having held them at multi-year lows for almost six months.

In open market operations on Tuesday, the central bank allowed the 28-day repo rate to rise 5 basis points to 0.95 percent and the 91-day repo rate to rise 4 bps to 1.00 percent, the first rises since November 2007.

On Thursday, the bank allowed its three-month bill yield to rise 6 bps to 1.0279 percent at auction, the first rise since February 2008.

TIGHTER LIQUIDITY

Expectations that the central bank will become less generous with money market funds and allow their rates to rise slightly have combined with a resumption of IPOs to convince the market that liquidity will be tighter in the second half of the year.

Chinese regulators have given Sichuan Expressway Co final approval to float shares in Shanghai in the mainland's first major IPO since last September, after three smaller IPOs were given the green light last month.

So banks may accept a new floor of 1.2 percent or higher for the weighted average seven-day bond repurchase agreement rate , closer to average funding costs that take into account deposit rates.

The repo rate mostly held to a range of 0.9 to 1.0 percent in the first half of the year, but broke out nearly two weeks ago when the first of the recent IPOs received formal approval.

It jumped by as much as 15 bps to a six-month high of 1.3253 percent on Thursday after the rise in the three-month bill yield at auction and news of Sichuan Expressway's planned IPO.

'The 7-day repo is unlikely to fall below 1.0 percent because of a continuous IPO pipeline,' said Qian Bingzhong, liquidity management officer at Bank of Communications. She expected popular IPOs could push the 7-day repo as high as 1.5 percent.

(Editing by Edmund Klamann and Neil Fullick) ((If you have a query or comment on this story, send an email to news.feedback.asia@thomsonreuters.com) Keywords: CHINA MARKETS/DEBT .

(karen.yeung@thomsonreuters.com; +86 21 6104 1783)

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