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People's Bank of China raised rates by 25 basis points on Saturday, the second rate rise in just over two months, as part of a series of measures designed to combat inflation which hit a 28-month high of 5.1 percent in November.

"Our economists had expected a rate rise before the end of the year, but releasing the news on Christmas Day itself came as a little surprise to the market," said Chen Xin Yi, associate vice president at Barclays Capital in Singapore.

"Nevertheless, we believe that the well-calibrated timing reflects consideration for minimizing unwanted financial market volatility and reducing potential capital movement to the extent possible."

The MSCI index of Asian stocks outside Japan .MIAPJ0000PUS rose 0.2 percent. Major markets such as Hong Kong and Australia remained closed.

"The impact of today's rate move on the real economy's growth momentum is likely to be minimal." said Qian Wang, chief China economist at JP Morgan.

China's key stock index .SSEC pared earlier gains and yuan forwards were modestly higher. The Shanghai Composite was down 0.3 percent, with weak small and mid-cap shares offsetting mild gains in banking and insurance shares.

Japan's Nikkei .N225 closed up 0.75 percent, extending its recent outperformance versus other Asian markets. The Nikkei is up over 10 percent this quarter versus a 5.4 percent rise for the MSCI Asia ex-Japan index.

Still, Japanese investors are entering 2011 in a bullish mood, raising equity holdings to a 10-month high, increasing exposure to high-yield credit and cutting back on government debt, Reuters polls showed last week.

S&P futures were a shade lower, down 0.2 percent.

FUNDAMENTALS SUPPORT COMMODITIES

Commodity markets pared early losses in response to an interest rate rise by PBOC, focusing instead on positive fundamentals and threats to supply.

U.S. wheat had dropped by more than 2 percent at the open before recovering to $7.81-3/4 a bushel, down 0.2 percent, while spot gold was trading flat after dropping to a one-week low of $1,371.1 earlier.

Crude oil futures reversed early falls, rising 0.3 percent to a two-month high.

The Australian dollar was flat after slipping in early trading on expectations that more tightening by China could prompt investors to sell the Aussie after the year-end break.

(Additional reporting by Nick Trevethan in SINGAPORE and Anotoni Slodkowski in TOKYO; editing by Kazunori Takada)

The Dow, the S&P and the Nasdaq on Thursday were up more than 5 percent on the month, and the level of optimism in the market was at a six-year high. The CBOE Volatility Index VIX .VIX, known as Wall Street's fear gauge, was down by two-thirds from this year's peak in May.

"I would think that the Santa Claus rally will continue into next week as there are still lots of mutual funds trying to beat or at least meet the performance of the S&P 500 within the calendar year of 2010," said TD Ameritrade's chief derivatives strategist, Joe Kinahan, who is based in Chicago.

"The VIX is also telling us that the market is expecting low volatility, which would also support upside movement."

China's Christmas day rate increase could spoil the party early in the week as the mammoth economy grapples with inflation, threatening to dent global trade. The rate rise was widely expected, though its exact timing came as a surprise. Illiquid markets next week could exaggerate any sell-off.

Some contrarian analysts were also more cautious as optimism at peak levels is usually a sign of a pullback and thus, negative for equities.

"We are continuing to make new highs as volume tails off, and the question is -- will it lead to some potential weakness into early next year?" said Ryan Detrick, senior technical strategist at Schaeffer's Investment Research in Cincinnati, Ohio.

"We think there could be a correction of 5 to 7 percent" toward the second half of January, he said.

BULLS IN CHARGE

According to the latest AAII Sentiment Survey, the level of optimism in the market rose 13.1 percentage points to 63.3 percent in the week ending December 22, the highest since November 18, 2004.

The level of pessimism was at the lowest since November 24, 2005, and the bull-bear spread was at the highest since April 15, 2004.

The AAII Sentiment Survey measures the percentage of investors who are bullish, bearish and neutral on stock market for the next six months.

Investor's Intelligence report, another indicator for market sentiment, showed 58.8 percent bulls for the week of December 17, the most bulls since the S&P 500 peaked in October 2007, when 62 percent of the respondents were bullish.

"Currently, bullish sentiment has been rising, but we feel optimism is not widespread and only skin deep, which means that investors are likely to turn bearish at the first downtick," said Bruce Bittles, chief investment strategist at Robert W. Baird.

"If bullish sentiment persists into late January, it would become more worrisome."

"It is unlikely that OPEC holds an emergency meeting ... There is a balance between supply and demand in the market ... It is possible that the price of crude reaches $100 per barrel," Khatibi said, SHANA reported.

Oil hovered around its highest levels in more than two years on Friday, supported by cold weather across the globe, appetite for risk assets and signals from OPEC it would not arrest the rally.

"In the opinion of the experts there is no need for an emergency OPEC meet under stable oil market conditions," Khatibi said.

Analysts said oil could continue its rally on strong global demand and falling inventories in 2011, which promises to be a strong year for risk assets as confidence about the global economic recovery picks up.

Khatibi said various issues could increase the price of oil.

"The outbreak of unprecedented cold in Europe, America and China, the weak dollar and increased demand for fuel due to the holiday season have raised the price of oil to more than $90," Khatibi said.

(Writing by Parisa Hafezi, Editing by Ron Askew)

On Christmas Day, the PBOC raised rates by 25 basis points, the second rate rise in just over two months, part of a series of measures designed to combat inflation which hit a 28-month high of 5.1 percent in November.

The opportunity to cash in on prices at or near their highest in years before the year end could mean the correction this time may be greater than the losses following the last interest rate hike in October.

While the market expected China to raise rates, some investors had thought it was too late to move in 2010, and for that reason China's commodity markets may test their downside limits on Monday.

"This certainly doesn't spell the end of the commodities boom or the strong China story. It's a smart move that may have caught the market off guard," Mark Pervan, senior commodities analyst at ANZ said.

"This may give some impetus for some profit taking before the end of the year, and an opportunity to buy on dips."

U.S. oil ended last week around a two-year high, above $91 per barrel while soybeans surged to a 27-month high, and copper flirted with record peaks.

Some analysts said after a lower open, markets could rebound and even hit new highs. Because the rate hike was modest and overall the real deposit rates are still in the negative territory. Money supply was not tightened strictly enough, Gu Jianjun at Jinyuan Futures said.

Western markets, such as corn and soy futures on the Chicago Board of Trade, may be particularly choppy, as the kneejerk reaction to the rate move is accentuated by holiday-thinned volume.

When China last raised interest rates in mid-October, it sent the dollar higher, dragged gold down by more than 2 percent, oil fell 4 percent, copper lost almost 2.5 percent, and losses of 2.7 percent in wheat and 2 percent in corn.

But that, and other policy tightening choppy did little to slow commodities' march higher.

China is the world's top consumer of a host of commodity products, including copper, iron ore, coal, cotton and soy and is the second largest consumer of corn, gold and crude oil.

The Reuters-Jefferies CRB index .CRB, which tracks 19 commodities, fell almost 2 percent.

Assessing the effect on some markets will be complicated by the Christmas holidays which see British-based markets such as the London Metal Exchange and London-based agricultural contracts, including softs, on NYSE Liffe closed on Monday and Tuesday, while markets in China and the United States reopen on Monday.

"It is a little bit of a surprise, but the move should be welcomed by the market. The central bank has increased the interest rates before the end of 2010, which means the possibility of increasing interest rates in the beginning of 2011 will be smaller," said He Yifeng, analyst at Hongyuan Securities in Beijing.