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China’s bond yields have fallen to record lows as investors respond to deflationary forces in the world’s second-largest economy and shrug off repeated warnings from the central bank that a bubble is forming in the sovereign bond market.
The yield on the 10-year bond, which moves inversely to prices, fell to 2.13 per cent on Thursday while 30-year note yields also dropped to 2.37 per cent.
Investors have been defying warnings from the People’s Bank of China that the frenzied buying risks creating a Silicon Valley Bank style banking crisis. Last month the central bank revealed its readiness to intervene in the market for the first time in decades to prevent a sharp fall in long-term yields.
“The PBoC has been battling with bond investors over long-end rates for some time, but with limited success so far,” said Larry Hu, China economist at Macquarie in Hong Kong.
Investors’ confidence in China’s sovereign debt has been bolstered by its spluttering domestic economy.
China’s economy grew 4.7 per cent year on year in the second quarter, hit by weak consumer demand and a prolonged property slowdown. Its manufacturing activity fell for a third consecutive month in July, while CPI is still just around zero. The slowdown has pushed investors out of stocks and real estate and into long-dated sovereign bonds this year.
As the domestic economy struggles to pick up, investors have bet that yields will fall further as Chinese policymakers are forced to intervene more deeply in the economy. That may mean cutting interest rates to stimulate investor demand, depressing yields.
But that has ratcheted up pressure on the PBoC as it tries to raise yields to prevent a bubble from emerging.
One of the central bank’s weapons is to exert its influence on market rates that banks lend to each other and to sell sovereign bonds on the secondary market to shore up yields. But last week, in a policy swing, the PBoC surprised the market with a slew of interbank interest rate cuts, and did not explain how it would keepdefending yields under lower rates. That about-turn sparked another round of intense government bond buying.
“The main issue right now is that PBoC’s credibility isn’t strong enough, which is why the battle with the market remains intense, and why verbal warnings alone barely work,” a Hong Kong-based senior executive at a European bank said. “At the end of the day, the central bank can always prevail [in the battle]. But the strength of its credibility determines the cost of its victory,” he added.
After issuing repeated warnings through June, PBoC shifted from talking about the problem to arming itself for direct market intervention.
In early July, it disclosed deals with several institutions to borrow several hundred billion renminbi of long-dated bonds, which it could sell into the market to meet demand. Many analysts believe this strategy, if the central bank went ahead with it, would provide the PBoC with a crucial tool to create a floor for long yields.
Nevertheless, investors have continued to ignored both the PBoC’s warnings and the potential firepower at its disposal.
A growing number of traders are engaging in what is known as “curve flattening,” where they anticipate minimal differences between short-term and long-term bond rates, according to a bond trader at a state securities firm in Beijing. “It signals a lack of confidence in the market’s growth potential,” he said. “That’s what worries the PBoC.”
Some fund managers see that as a risk too far, even in a bullish market. Wei Li, a portfolio manager at BNP Paribas Asset Management, cautioned against trying to “play around” the yield curve in opposition to central bank policies, when the central bank potentially had the ability to force yields higher at short notice.
He argued that a marginally lower long-term yield was inconsequential as long as the PBoC can achieve its objective of engineering an optimal shape of yield curve.
“If they set a target, they can certainly meet it,” Li said. “However, the PBoC’s real goal is to establish an ‘upward sloping yield curve,’ where short-term yields are lower to facilitate business development, and long-term yields are higher to encourage investment.”
However analysts warn that the PBoC’s goal of higher yields to stave off a SVB-style collapse in the banking system is clashing not only with the market but the finance ministry’s desire for lower yields, since it would mean the government could issue bonds at a lower cost.
“It takes both guts and time to prove the market is wrong or validating that the PBoC is correct. However, time is not always an ally of the central bank,” the researcher said.
