China’s bull market in bonds on borrowed time

As recently as October, investors could be forgiven for believing that China’s bull market in bonds had miles more to run.

With economic growth slowing and wholesale prices mired in deflation, the People’s Bank of China flooded the banking system with cash, keeping money-market interest rates at rock bottom levels. Investors were confident the central bank would have little choice but to continue easing, both to keep growth humming and to prevent a rise in debt servicing costs on China’s growing pile of corporate debt. 

Now there are signs that the bond market faces a big test after the 10-year government yield soared to an 18-month high of 3.33 per cent late last week. Trading in 10-year government bond futures was briefly suspended after they fell by the maximum 2 per cent daily limit — the first such suspension since futures were relaunched in 2013. 

The immediate trigger for the market disquiet was an indication from the US Federal Reserve that it may tighten policy faster next year than previously expected. A rate increase last week from the US central bank, and signal of more to come, places China in a bind by adding to capital outflow pressure that is weighing on the renminbi exchange rate.

However, the Fed’s action was only a proximate cause. Even before last week investors were facing a series of challenges, led by an improved macro outlook, capital outflows and a PBoC move to to contain a bond bubble. 

With cheap cash sloshing through the system and attractive investments in the real economy remaining scarce, investors had ploughed plenty of money into bonds. China’s 10-year government bond yield fell from 4.6 per cent in January 2014 to 2.65 per cent by late October. 

“It’s a typical carry trade — borrow overnight and buy longer-dated bonds. But the requirement for this trade is stable and low money-market rates. That’s what makes financial institutions feel comfortable adding more leverage,” says Shan Kun, head of China local markets strategy at BNP Paribas in Shanghai. 

“If this leverage continues, it means any volatility in monetary policy will create huge reverberations in the bond market because everyone is trading in the same direction.” 

With China’s 10-year government yield still elevated at 3.28 per cent on Monday, the risk of volatility increasing is a clear concern for the market. As with the US Treasury market, concerns over inflation are pressuring bond prices and pushing up yields.

The rebound in commodity prices against a backdrop of increased demand from China’s industrial economy has led to a sudden revival of inflation. The economy’s producer price index was in negative territory for more than four consecutive years through August. By November, PPI had surged to 3.3 per cent, the fastest pace in nearly five years. 

“I don’t think the PBoC is trying to tighten because of inflation, but that is a concern for markets. It’s a bit like in the US — yields moved up even without the Fed actually raising rates because inflation expectations increased,” says Wang Tao, China economist at UBS in Hong Kong. 

In addition, the PBoC has engineered a steady tightening of money market liquidity since the summer. The overnight bond repurchase rate has averaged 2.26 per cent so far in December, compared with only 2.02 per cent in August. Higher interest rates force bond investors to trim their holdings as the carry trade becomes less attractive. 

Tighter liquidity has been a side-effect of the PBoC’s response to capital outflow and the weakening renminbi. When the PBoC sells dollars from its foreign exchange reserves to support the exchange rate, the central bank balance sheet shrinks and China’s money supply contracts.

Foreign exchange purchases were once the central bank’s primary tool for creating new money. But as forex inflows turned to outflows over the past two years, the PBoC has resorted to alternate tools. The most important of these is “reverse repos”, a form of open market operation in which the central bank lends seven- and 14-day cash to commercial banks. 

Yet the PBoC has been stingy with its reverse repos in recent weeks. Market participants say the PBoC is taking advantage of capital outflows to squeeze leverage out of the bond market. By calibrating the volume of its reverse repos, the PBoC can passively guide short rates upwards. Higher interest rates have the added benefit of discouraging capital outflows by increasing the returns available on renminbi assets.

“The market is looking at open market operations and drawing conclusions about the PBoC’s intention for monetary policy next year,” says Raymond Yeung, chief China economist at Australia and New Zealand Banking Corp. 

The PBoC appears to be engaged in a modified version of “Operation Twist” — the Federal Reserve’s move in 2011 to bring down long-term interest rates while letting short rates rise. Even as it has pulled back on short-term cash injections, the PBoC provided Rmb394bn in six- and 12-month loans to 19 banks through its medium-term lending facility. 

Policymakers hope that injecting longer-term cash will help contain lending rates to the real economy — including home mortgages and corporate loans — while reducing the dangerous maturity mismatch from overnight borrowing used to fund long-dated assets. 

“The PBoC has shown clear intention to deleverage the bond market. But the central bank doesn’t want to see a credit crunch either,” according to Larry Hu, China economist at Macquarie Securities.

Twitter: @gabewildau