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UPDATE 1-Hong Kong interbank rates jump, pull HKD off band extreme

(Adds analysts' comment and Hong Kong dollar levels)

By Tom Westbrook

SINGAPORE, May 10 (Reuters) - Hong Kong interbank rates jumped on Wednesday as a further decline in banking system cash balances spurred expectations of tightening monetary settings and to an unwinding of short positions in the pegged Hong Kong dollar.

The overnight Hong Kong Interbank Offered Rate shot up nearly 92 basis points to 4.4381%, its highest since December 2019.

One-week HIBOR rose about 48 bps to 4.10952% and one-month HIBOR hit its highest since January at 4.15762%. The Hong Kong dollar rose to its strongest since the middle of February at 7.8325 per U.S. dollar.

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Hong Kong rates are tethered to the U.S. by the Hong Kong dollar's peg to the U.S. dollar, and have been rising for a few weeks. The city's currency is pegged to the greenback in a tight range of 7.75-7.85 per dollar.

The spikes in interbank rates came on the back of the decline in the aggregate balance - a key gauge of cash balances in the banking system - which at HK$44.5 billion is now at its lowest level since 2008 and expected to drop further.

The aggregate balance has been falling steadily this year as the de facto central bank, the Hong Kong Monetary Authority, intervened to defend the peg at 7.85 against the force of investors borrowing the currency for carry trades.

Yet interbank rates were pinned to lows as weak loan demand and investment inflows into Chinese assets kept the banking system flush.

Analysts pointed to waning optimism on China and a decision by Hong Kong banks to raise their prime lending rates this month as reasons for the spike in Hibor.

Banks seemed to be selling down their more than a trillion Hong Kong dollars worth of holdings in the city's Exchange Fund Bills and Notes (EFBNs) to raise cash, driving yields on one-month bills up half a percentage point this month.

That in turn has caused 3-month spreads between U.S. dollar Libor and equivalent Hibor to compress to 130 basis points from a historically wide 175 points just a few weeks ago.

"The reversal of capital inflow to outflow (i.e. reducing HKD supply) from the reopening trade, if taking place, will pose upward pressure on HKD rates," wrote Ken Cheung, chief Asian FX strategist at Mizuho Bank.

"The narrowing of the U.S. and Hong Kong dollar rate spread prompted traders to unwind the carry trade positions."

(Additional reporting by Georgina Lee in Hong Kong Editing by Vidya Ranganathan and Raju Gopalakrishnan)