Are the glory days over for the China convergence trade? The world is in turmoil, investor perceptions are in disarray and cosy notions about Chinese interest rate and bond yield convergence to the
United States are open to question. Chinese yield spreads over the US are so wafer thin, further narrowing may be pushing the boundaries of risk-reward credibility. China’s government bonds may be a novel diversification opportunity for investors, but perceptions of “fair-value” might have reached the end of the road and spread divergence may be the next step for investors.
This isn’t good news for China’s renminbi and is a potential problem for an economy still dependent on valuable inflows of funds from abroad to help supplement domestic funding requirements. At a time when China’s domestic credit expansion has been slowing, it’s also not the best news for growth. Global economic uncertainties are rising, leaving China’s economy and currency stability more vulnerable.
What convergence bulls look for most in global markets is robust outperformance. Looking at the state of play in China’s
bond and equity markets right now, there is not much to get pumped up about. Interest rate and yield convergence plays look spent, China equity market prospects have faded, thanks to weaker growth prospects, and the outlook for the renminbi is fragile. With financial markets under a cloud, the argument for greater investor caution is strong.
While nothing is cast in stone on convergence trades, investors have important rules of thumb to follow. Generally, yield convergence trades work best when bond markets are in a bull phase, interest rates are in easing mode, the target currency is strong, relative yield appeal is high, global stability risks are low and investor confidence is positive. Right now, the outlook is mixed, with little reason for investors to stick their necks out too far.
While world bond markets have seen lower yields in recent months, with investors fearing the worst for global growth thanks to the
US-China trade war, the jury is out on whether the recent bond rally is nothing more than a temporary blip. With US
Federal Reserve tightening acting as a buffer to dynamic domestic growth, the longer term trend for US treasury yields is still skewed to the upside – especially if Washington and Beijing manage to patch up their differences over trade. It’s too early to say the Fed’s tightening cycle is over just yet.
