It is probably a coincidence that one day after we commented on what is emerging as “the market’s next headache”, namely China’s (not so) stealth tightening, which in the last few weeks has led to a creep higher across the curve, the yield on China’s sovereign 10Y bond jumped 6.5bps to 2.94% on what Bloomberg dubbed were “liquidity fears.” This was the biggest one day spike for the benchmark bond since Jan. 25, according to ChinaBond data.
As a result of the selloff, the most actively traded 10-year govt bond futures were down 0.72%, while five-year futures dropped 0.74%.
The tightening was broad-based, with 1-year rate swaps rising 13bps to 19-month high at 3.17%; additionally the overnight repo rate also rose to 2.31%, the highest level this month.
Quoted by Bloomberg, Wu Sijie, bond trader at China Merchants Bank said “tightening interbank liquidity and the expectation of even higher short-term borrowing costs are driving up swap costs and affecting sentiment on the cash bond market.”
Meanwhile, signalling no change at all in its posture, overnight the PBOC drained funds in open-market operations for the fourth consecutive day, bringing the total withdrawal to 130 billion yuan.
As we reported yesterday, “since Oct 21, yield of 10Y Chinese Government Bond (CGB) has risen by 20bps, from 2.65% to 2.85%, partly in response to the strong global rates and USD move since the US election.” Bank of America expects Chinese yields to rise further to 3.40% by the end of 2017. Furthermore, with credit spreads near all-time lows, the bank warns that there is a risk that the move can widen sharply in the near future.
Judging by the biggest jump in yields in over a year taking place the very next day, this appears to be playing out as expected.
As Cui wrote, the local equity market reacted progressively less favorably to rising rates the last four times as investors turned ever less optimistic about growth outlook. The bank believes that “the rising rates this time may put pressure on equities in general as it would occur in an environment of lackluster growth.” In other words, while the US stock market may be ignoring the signal sent by rapidly rising yields, China may not have that luxury.
The biggest concern: if rising rates are caused by no-growth factors, such as inflation and the government’s desire to control debt growth (which seemed to be the case with Episodes 3 and 4), the market reacted sharply lower. This time, the pressure appears to be mainly driven by a less accommodating monetary policy as a result of housing bubble risk, debt control need and exchange rate pressure, despite a fairly lackluster economic growth outlook. In this case, Cui concludes, “the rising rate should not be a net positive to the equity market, in our view.”
Finally, what is most troubling for China, is that should financial conditions continue to grind tighter, the PBOC may have little recourse in response: as the Yuan has tumbled on the back of the stronger dollar, the central bank has been forced to tighten conditions to avoid an even steeper descent. This has eliminated the possibility of engaging in further aggressive easing as the alternative would be an even sharper drop in the Yuan, leading to even greater capital flight – something Beijing has been grappling with since early 2015.
Ultimately, the sharp move higher in Chinese yields may mean that just as “international conditions” prevented the Fed from hiking any time after the December 2015 rate hike, so this time too it may be global tightening conditions, and the stronger dollar that cause the next round of capital markets pain in a repeat of the market’s reaction to the last time the Fed hiked to telegraph the economy was “strong enough” that it could sustain a tightening cycle. It wasn’t.
So while traders have gotten used to tracking the daily fixing of the Yuan, keep a close eye on Chinese yields too. At this point it may be they that crack first.