* Shanghai Composite seen down 3 percent or more Wednesday
* Yuan rise to stall near 6.65/USD to deter hot FX inflows
* Medium/long-term bond yields could rise 10 bps or more
* Expect volatility in days ahead on the big surprise
By Lu Jianxin and Eric Burroughs
SHANGHAI/HONG KONG, Oct 19 (Reuters) - China's surprise rate hike could drive down Shanghai stocks more than 3 percent on Wednesday, but the yuan's rise may be halted to prevent an influx of foreign funds from heading into the country.
The People's Bank of China surprised investors by lifting benchmark deposit and lending rates by 25 basis points each, a move that had not been expected until 2011 and sparked a broad drop in risky asset across the world.
The move, taking one-year deposit rates to 2.5 percent and one-year lending rates to 5.56 percent, suggests the government is not happy with the recent run-up in asset prices, including a 15 percent jump in the Shanghai Composite in just eight trading days and a rebound in property prices despite repeated steps to cool the red-hot real estate sector.
The PBOC may also be worried about hot money coming into the country as the Federal Reserve is expected to follow the Bank of Japan in boosting quantitative easing measures.
* China's benchmark Shanghai Composite could fall 3 percent or more as investors turn nervous about quicker-than-expected of monetary policy and take profits on the sharp jump this month.
* The rate hike, plus clear signs that China's inflation is picking up to its fastest in two years, will keep investors nervous that China is entering a stretch of high inflation that has historically been bad for domestic stocks.
* Property shares, which have contributed to the Shanghai Composite being a laggard among global stock markets this week, will again be hit hard as the rate hike increases their borrowing costs from banks. The Shanghai Composite property sub-sector is still down 17 percent on the year compared with 8.4 percent for the overall index.
* The hike also suggests that Beijing may choose to stop the yuan's recent appreciation after the Chinese currency has risen 2.5 percent since early September, its biggest pace of gain since the yuan's landmark revaluation in July 2005.
* Spot yuan is likely to move around 6.65 against the dollar and could move around that level for some time as the PBOC tries to stamp out expectations for more yuan appreciation and ward off funds lured by China's higher rates.
* The government, which had been expected to allow the yuan climb to near 6.60 to the dollar by mid-November in response to U.S. pressure, may bluntly stop yuan appreciation.
* While China's capital controls in theory prevent money from coming into its domestic markets, that cash tends to find a way in. Anecdotal evidence has suggested a return of hot money inflows, such as turnover on the Shanghai Composite hitting a record high on Monday.
* Chinese government bond yields will rise across the curve, with medium- and long-term yields having the potential to jump 10 basis points on worries that the PBOC is embarking on a series of rate hikes in coming months.
* The seven-day bond repurchase rate, China's money market benchmark, should reverse a drop due to excess liquidity in the system. The seven-day repo rate should snap back above 2 percent versus Tuesday's close of 1.91 percent.
* That compares with the new one-year deposit rate of 2.5 percent and the one-year lending rate of 5.56 percent.