Don’t look to US Treasuries’ rally to understand the ‘sticky’ yields in Chinese government bond market

Rather than US Fed moves, it’s the uncertainties on China’s economic, policy and inflation fronts that explain the lack of direction in the Chinese government bond market
Amid slowing growth momentum, there is room for Chinese bond yields to trend lower

Hao Zhou

Published: 2:30pm, 4 May 2021

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Different from the “fast and furious” US Treasury market, China’s onshore bond yields have been stagnating since the fourth quarter of 2020, which has puzzled many investors.

For instance, the benchmark 10-year Chinese government bond (CGB) yields have been hovering around 3.2 per cent over the past few months, with little sign of changing dynamics or direction. Naturally, investors are curious about the reasons behind the “sticky” yields in China’s “boring” bond market.

First, although the consensus view sees China extending its economic recovery, the overall outlook remains uncertain. China’s gross domestic product growth is likely to have peaked in the first quarter of 2021, implying a slowdown in momentum.

However, there is still hope that improving global demand will provide additional impetus to the Chinese economy, and domestic consumption could see further recovery as more people are vaccinated.

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Nonetheless, risks still loom, including worsening US-China tensions as the Biden administration ramps up pressure over climate change, democracy and human rights. In addition, concerns about a retreat from accommodative monetary policy and a property bubble still cloud the economic outlook.

On the liquidity side, market interest rates have remained stable for months, and the open market operations conducted by the People’s Bank of China show little policy bias, for now. As a result, the leverage trading volume remains manageable.

So-called leverage trading means that bond traders can buy and hold bonds, and use the bonds as collateral to borrow money, then purchase bonds again. The higher the leverage ratio, the more speculative the sentiment.

The market normally uses the repurchase agreement (repo) trading volume as a proxy to illustrate the leverage trading dynamics in the bond market. This suggests that overall bond leverage remains low in the market and views on bond markets are diversified.

Obviously, the inflation outlook also matters for the bond market, and a mixed picture unfortunately gives little guidance for traders. While producer price index (PPI) inflation is rising rapidly and will probably continue to climb in the foreseeable future, there is little sign of runaway inflation any time soon.

Core inflation, excluding food and energy prices, remains low, suggesting there is little visible inflation risk in the Chinese economy.

PPI inflation, driven by global reflation and surging commodity prices, has concerned Chinese policymakers somewhat. However, given that this is largely imported, Beijing has few effective policy tools to contain the prices of imported goods.

Hence, the baseline inflation scenario is probably an extrapolation of current inflation dynamics, which means consumer price index (CPI) inflation will remain abated, while PPI inflation continues the rise.

A question here is whether surging PPI inflation will be passed on to CPI inflation, which would result in monetary policy tightening.

From a theoretical perspective, this may happen. However, there has been little correlation between PPI inflation and CPI inflation since 2015, which indicates some structural change in China’s inflation profile.

In fact, when PPI inflation surged in 2017 due to supply-side reforms, China’s CPI remained stable. All told, uncertainty remain high for China’s inflation outlook, which can also explain the directionless bond market.

Put simply, uncertainties exist on the economic, policy and inflation fronts, which explains the lack of direction in the bond market. A more important question is how things will play out in the future, particularly in the second half of this year. My view is that there is room for bond yields to trend lower.

First, after China registers stellar growth for the first half of 2021, headline growth will probably approach sub-6 per cent in the second half. Therefore, the slowdown will be more visible, which could lead to more confidence to enter the bond market.

Second, the targeted tightening in the property market could trigger credit events among Chinese companies and financial institutions, which would probably dampen risk sentiment. In such a scenario, Chinese government bonds may well be preferred as a safe haven.

Third, China’s PPI inflation is likely to peak late in the second quarter or early in the third, given the relatively high base and slowing momentum in commodity prices. In this case, the market would see a reduced risk of inflation, and turn its focus to slowing growth momentum.

A frequently asked question is whether rising US bond yields would lift China’s bond yields. While that may sound reasonable, history suggests there is no strong correlation between the two.

One explanation is that the PBOC does not closely follow the Federal Reserve’s policy direction, and China normally has a different political agenda from the US. Therefore, it would make more sense to track China’s economic and policy dynamics to trade in the Chinese government bond market.

For foreign fixed-income investors, an important consideration is the foreign exchange risks embedded in the bond market. Indeed, given the rising dollar yields and improving US economy, the risk of a strong dollar is clearly on the table. As such, foreign investors might need to hedge foreign exchange exposure in the forward market, where hedging costs are already on the rise.

Hao Zhou is senior emerging markets economist at Commerzbank

This article appeared in the South China Morning Post print edition as: Behind the ‘sticky’ yields

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