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Bond yield curve inverts, as traders fear tighter liquidity

Market jitters continue on the outlook of sharply tighter domestic rates, especially after recent soft economic data

PUBLISHED : Friday, 09 June, 2017, 3:53pm
UPDATED : Friday, 09 June, 2017, 10:18pm

China’s regulatory efforts to curb lending in the financial markets are causing traders to dump short-term bonds, creating a rare inversion in the Chinese Treasury Bond yield curve.

A normal yield curve slopes upwards because longer-dated bonds should carry higher returns than shorter-dated ones, to compensate for the chance of risk events occurring within a longer investment time frame.

But a surge in bond yields of 115 to 150 basis points since October has created inversions in several parts of China’s curve.

The one-year yield is trading at 3.665 per cent on Friday, above the 10-year yield of 3.655 per cent – its first inversion for the spread on record – its first inversion for the spread on record.

While China is aiming to reduce risk in the shadow banking sector, analysts suggest it is creating an inverted yield curve as traders buy the long-term bonds and dump short-end notes in preparation for a potential cash crunch.

“Traders would rather buy 10-year bonds because they are more easily sold if there is major funding squeeze,” said David Qu, markets economist at ANZ.

“They are avoiding the short end, however, especially one-year notes, given their over-supply.”

An inverted yield curve typically occurs when a central bank believes economic growth and inflation will be higher, but bond investors are not convinced of this.

In the US, an inverted yield curve correctly predicted the last seven recessions, when short-term interest rate yields were higher than longer-term rates.

China is unlikely to see a recession anytime soon, given it is still considered a developing nation.

It’s last one was from a different era in the 1960s/1970s. But its target of 6.5 per cent economic growth in 2017 will be its slowest pace this century.

There are certainly market fears, too, that the current bout of regulatory tightening aimed at wealth management products may be too aggressive, and that may lead to sharply tighter domestic liquidity conditions which in turn would increase risk in other parts of the financial sector.

“Overly fast and strict tightening could easily cause liquidity problems to small- and medium-sized Chinese banks because they have relatively high borrowing costs, and this could spread to the entire financial system,” according to Chinese research company CEBM Group analysts Zhong Zhengsheng and Zhang Lu.

The People’s Bank of China seems to be already shifting to a more neutral monetary policy stance from one with a tight bias in an effort to alleviate pressure from the tight financial regulations in order to avoid such market panic and systemic financial risks.

Overly fast and strict tightening could easily cause liquidity problems to small- and medium-sized Chinese banks because they have relatively high borrowing costs, and this could spread to the entire financial system
Zhong Zhengsheng and Zhang Lu, CEBM Group analysts

The central bank has also recently signalled it will avoid a excessively weak yuan in an effort to ward off capital outflows that would add to tighter domestic liquidity conditions.

It tweaked its formula in calculating the daily yuan reference rates while it is said to have also engineered a spike in offshore yuan rates that was aimed at crushing speculators which are bearish on the currency.

“Any fears of a one-off depreciation that is similar to the sharp yuan drop seen in August 2015 is now off the table,” according to Neeraj Seth, head of Asian credit at BlackRock.

However market jitters continue on the outlook of sharply tighter domestic rates, especially after recent soft economic data.

Caixin/Markit Manufacturing Purchasing Managers’ index fell to 49.6, below the 50-point mark, showing contraction for the first time in nearly a year.

Producer price index inflation data, released on Friday, also slowed to 5.5 per cent from a year earlier in May because of easing food prices. The data points to a continuing lower trend for the rest of the year, which accompanied with a rise in funding cost would lead to increasing real interest rates for Chinese corporates, Qu said.

The average loan interest rose to 5.53 per cent at the end of the first quarter in 2017, compared with 5.2 per cent at the end of 2016, according to the quarterly central bank monetary policy report.

“The inverted yield curve is unlikely to go away for now,” he adds.

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