This analysis is by Bloomberg Intelligence Analyst Chief Asia FX and Rates Strategist Stephen Chiu and Bloomberg Intelligence Senior Associate Analyst Jason Lee. It appeared first on the Bloomberg Terminal.
The selloff in China’s treasury bonds of late could be a window for strategic investors with a longer-term investment horizon, as the current bear-flattening trend may not be sustainable given China’s is unlikely to drain interbank liquidity continuously or hike rates in light of the uncertainties about its macro recovery.
China treasury curve’s bear flattening might not last
China’s treasury bond (CGB) curve has bear flattened (shorter end yields rose faster) abruptly of late, along with the selloff in other short-duration papers like the negotiable certificates of deposit (NCDs), yet this trend may not persist and yields could stabilize before year-end. This rates squeeze was only likely due to the market’s disappointment about the lack of monetary easing plus concerns about a year-end interbank liquidity squeeze, with the selloff being further amplified by the redemption of onshore bond funds. A sustainable bear-flattening move may need to be backed by more evidence about a robust macro recovery, so that China could afford to consider monetary tightening instead of easing. This may not be the case at this point.
The one-year/10-year spread might have support near 60 bps.
One-year MLF rate at 2.75% could act as an anchor
There may be limited upside for the 10-year CGB yield and also the one-year NCD yields if the People’s Bank of China (PBOC) keeps the one-year medium-term lending facility (MLF) operation rate at 2.75%, with the latter tending to act as a policy anchor for the former over recent years. Even if China is willing to further loosen its zero-Covid policy and hence likely to facilitate more effective transmission of the earlier monetary and fiscal stimulus, the PBOC should remain vigilant to not over-drain interbank liquidity and derail China’s macro recovery. We expect the 10-year yield to face resistance near 2.9%.
PBOC Governor also said that China intended to stick with normal monetary policy for as long as possible and to keep interest rates positive, while also maintaining an upward-sloping yield curve at the same time.
One-year treasury yield tracks policy-rate gap
China’s one-year treasury yield tends to track the gap between the seven-day depository-institute repo (Drepo or DR007) and the PBOC’s seven-day reverse-repo (RR) rate, as both measures reflect interbank liquidity. Even without a policy rate cut — the seven-day RR rate, for example — an increase in liquidity injections from the PBOC’s open-market operations or an RRR cut could cause the seven-day Drepo rates to fall below the RR rate, and drag the one-year China government bond yield as well.
The one-year yield jump of late may not be sustainable if the PBOC reverts to net injections to prevent interbank liquidity from tightening too fast, and the PBOC’s next move remains likely to be a policy-rate cut instead of a rate hike. The one-year yield may drop back to near 2%.
7-year/10-year yield gap: strategic vs. tactical
The spread between the 7-year and 10-year CGB yields could be viewed as a relative preference between strategic and tactical trading. Market liquidity tends to be thinner for the 7-year tenor vs. the 10-year, and hence only the strategic investors would be more receptive of the former amid their longer investment horizon. Conversely, tactical investors tend to opt for the 10-year tenor for quick turnover when expressing their views on China’s policy and macro outlook.
An inversion in the 7-year/10-year gap in a rising yield environment could be viewed as relatively higher selling pressure from the strategic investors vs. the tactical investors, and this might also be due to the bond-fund redemption. However, an inversion tends to be temporary and might be one window for strategic investors.
10-year yield might find stabilization for now
China’s 10-year treasury-bond yield may stabilize near 2.7% according to our indicators. One of the earlier-available indicator is the proxy demand for manufactured goods, as represented by the difference in new orders and stocks of finished goods sub-indexes from the official manufacturing PMI (white line in the chart) — with its trend (moving average of the monthly data) pointing toward somewhat higher yield, at least for now before external demand weakens. Another key indicator is the aggregate financing to the real economy (AFRE)-M2 growth gap, which showed signs of bottoming in the September data. This indicator might pick up further in 4Q if the existing fiscal and monetary stimulus channel through and lift credit demand — which could be what the market has tried to position via pushing up the short-end rates.
Bloomberg
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