As the last bauhinia petals in Hong Kong fluttered to the ground at the beginning of the month, many wondered if the bloom had also faded for the property and equity markets. Data released on Thursday showing a drop in property transaction volumes last month and a dearth of interest in the largest initial public share offering of the year were only the latest signs that Hong Kong had meandered off the sweet spot that it occupied for much of the second half of last year. Back then, Hong Kong was flush with liquidity as foreign capital clamoured for shares in China offerings. Dollar-rich speculators landed at Chek Lap Kok and Lowu to scour the city for still-cheap flats, certain that prices could go nowhere but up. Meanwhile, armed with a somewhat puzzling belief that a revaluation of the yuan would somehow rub off on the Hong Kong dollar, foreign exchange traders began buying the currency with gusto. The unprecedented capital inflows kept short-term interest rates at a record low - and at a deep discount to their counterparts in the United States - keeping the cost of money low. Because the Hong Kong dollar is pegged to the greenback, local assets appeared ever-cheaper to the outside world as the US dollar plummeted. But as temperature rose through the spring, so too did interest rates. Last month, when the Hong Kong Monetary Authority tinkered with the peg and the mainland ruled out an immediate revaluation of the yuan, liquidity rushed out of Hong Kong and interbank rates raced upwards to almost match those in the US. The benchmark three-month rate stands at 3.35 per cent, compared with 2.57 per cent before the peg adjustment on May 18 and 0.34 per cent at the beginning of this year. Banks responded to the latest surge by raising their prime lending rates by 50 basis points to 5.75 or 6 per cent, depending on their starting point, which instantly pushed up mortgage rates by the same amount. Property owners with 20-year mortgages paying $8,000 a month at the beginning of the year are now coughing up $8,600. Meanwhile, the US dollar has rebounded as the French and Dutch rejection of the European constitution stoked fears that the policy initiatives for the sluggish continental economy would remain disjointed and ineffective. Hong Kong dollar assets look pricier and riskier. 'Much of what has been driving the Hong Kong market no longer applies,' said Adrian Mowat, a regional strategist for Asia Pacific at JP Morgan. And as long as the US Federal Reserve continued to raise rates, Hong Kong rates would now have to follow, analysts said. This could mean another increase of 50 basis points in local lending rates this year, assuming the US federal funds rate moves to 4.25 per cent as expected. 'Hong Kong is likely to experience one of the largest moves in interest rates of any economy around the world. That challenges the outlook for the property market, particularly when luxury yields are very low,' Mr Mowat said. In short, the cheap-money party is over. The fact that higher rates deter property purchases was underscored by monthly transaction data this week showing that 8.76 per cent fewer properties changed hands last month than in April, when they had surged by 59 per cent over March. The number of residential units changing hands fell 11.76 per cent to 12,463. Fewer transactions, analysts say, will ultimately lead to lower prices. In a report published this week, Merrill Lynch projected that housing prices would slump between 20 and 25 per cent by the end of next year. The mood is only marginally more festive on the equity markets. Mainland coal producer China Shenhua Energy's issue, expected to yield up to $28.3 billion, met muted enthusiasm from retail investors on its Thursday launch, in stark contrast to the deluge of subscriptions received for initial offerings from China Power International Development, China Netcom Group Corp and Air China late last year, and Dynasty Fine Wines Group and I.T in the first quarter. One retail broker said it had received a meagre $13 million worth of orders for Shenhua shares in two days. Another noted that most of the interest had been in the form of cash orders for one or two board lots, rather than the large-scale subscriptions using 90 per cent margin financing that typifies the bullish buying of speculators. The lacklustre response for Shenhua may stem in part from fears that coal prices have peaked. Bank of Communications' US$2 billion offer, which will open for retail subscription on June 13, might be a better test of retail sentiment, brokers said. But the Hong Kong equity market has been slack for much of this year as the capital outflows and rising interest rates put off investors. At yesterday's close the Hang Seng Index was down 2.89 per cent for the year. Still, some analysts say the gloom is unwarranted. After all, the economy expanded 6 per cent year on year in the first quarter, as strong domestic demand offset a slowdown in exports. Unemployment is at a 41-month low of 5.9 per cent, the AC Nielsen consumer confidence index rose to a 16-year high in April and the surge in property prices have reduced the share of residential mortgage loans in negative equity to just 5 per cent from 31 per cent two years ago, according to an upbeat report by Lehman Brothers. The US investment bank also argued that, thanks to rising inflation, Hong Kong's real monetary conditions were 'still very loose and about to get looser'. 'For the short term, interest rates will continue to have a dampening effect on the market and risk appetite has clearly been dented by a whole series of domestic and global events, but I don't think it is fatal at all,' said Spencer White, a regional strategist with Merrill Lynch. 'We have some steam taken out - which is actually a healthy thing.' Indeed, the fear that property prices may get out of hand if monetary conditions are to remain loose seems to have been a trigger for the recent changes to the Hong Kong dollar peg, which is meant to deter yuan speculators from using the Hong Kong dollar and to bring local interest rates back in line with those in the US. In September 2003, when the speculative inflows started in earnest, US interest rates were at a 45-year low of 1 per cent. Huge capital inflows left local monetary conditions very easy, but according to HKMA chief executive Joseph Yam Chi-kwong, this was 'quite helpful for Hong Kong', which was still mired in deflation and had only just recovered from Sars. The conditions were different this year with the return of inflation, rallying property prices and a decline in the jobless rate, Mr Yam said.