Why bond investors should see China, not the US, as the ‘land of hope and dreams’

When Bruce Springsteen sang Land of Hope and Dreams at US President Joe Biden’s post-inauguration celebration, The Boss was clearly referencing the United States, but right now, in the bond space, investors might conclude that the song title is more applicable to China. There’s arguably more value in holding 10-year Chinese government bonds than the equivalent US Treasury. Biden’s administration, bolstered by Democratic Party control of Congress, will push through a massive fiscal package to help alleviate the devastating economic and social effects of a Covid-19 pandemic still raging across the United States. That will have to be financed, but apparently now is not the time to worry about borrowing costs. Urging Congress to vote for the massive fiscal package, Janet Yellen, Biden’s Treasury Secretary, argued last week that “right now, with interest rates at historic lows, the smartest thing we can do is act big”. “The world has changed,” the former Federal Reserve chief said. “In a very low-interest-rate environment like we’re in, what we’re seeing is that even though the amount of debt relative to the economy has gone up, the interest burden hasn’t.” But that “low-interest-rate environment” is essentially artificial, given the scale of the US central bank’s ultra-accommodative monetary policy response to Covid-19, with substantial monthly Fed purchases of US Treasuries helping to cap their yields. In short, US Treasury prices could be regarded as being higher, and thus offering lower yields, than markets might otherwise demand in the absence of the Fed’s footprint. Additionally, with the Fed having now adopted an average inflation target, US bond market practitioners can realistically conclude that, in the absence of a material and sustained rise in US consumer price inflation above the 2 per cent target, the Fed-influenced lid on Treasury yields will remain in place even after a new fiscal stimulus package is enacted. There’s a persuasive argument that fiscal stimulus allied to an expansive monetary policy is appropriate in the middle of a pandemic, but it can’t go on forever. Indeed, the more success the country has in suppressing the pandemic and in reinvigorating the economy, the greater the likelihood that the Fed will eventually conclude that its monetary policy should be less accommodative, even though the US government will still need to borrow vast amounts and service the associated debt costs. In such circumstances, without Fed support for Treasury prices, bond market vigilantes would surely put downward pressure on those prices, driving up yields in the process, whereas if the pandemic continues to rage, the US bond markets could also logically assume that the current situation will continue. Inflation fears are not unfounded but a nightmare scenario is unlikely It is not inconceivable that speculators could ultimately decide that being short on US Treasuries represents a better risk/reward ratio than staying long on them. But, if so, money coming out of US Treasuries would have to go somewhere else, and Chinese government bonds might be one destination. The US debt market is the largest in the world, with China next in line, but while foreigners own about one-third of the US Treasury market, less than 10 per cent of Chinese government bonds are held by overseas investors. Yet, the yield on the 10-year Chinese government bond is above 3 per cent, while that on the 10-year Treasury sits at just over 1 per cent. It would appear that, globally, bond markets are not only underinvested in Chinese government bonds as compared to US Treasuries, but in the process are also forgoing the higher yields that Chinese government bonds currently offer over US paper. Hong Kong iBonds, China bonds offer a haven for those seeking yields Such a stance might be understandable if investors could see that the foreign exchange risk of holding yuan-denominated Chinese government bonds was pronounced, but it’s not. Indeed, the yuan has been on an appreciating trajectory and the People’s Bank of China is putting the emphasis on keeping it stable. The renminbi “will remain basically stable at a reasonable and equilibrium level”, Sun Guofeng, head of the central banks’ monetary policy department said recently. Admittedly, Yellen said last week: “The world can be certain that the United States will not seek a weaker currency to gain competitive advantage.” But foreign exchange practitioners will recognise that is not the same as saying Washington would necessarily resist market-led US dollar depreciation. All things considered, the bond markets may consider that the risk/reward ratio seems skewed towards being long on Chinese government bonds. Springsteen’s Land of Hope and Dreams contains the lyrics “faith will be rewarded”. In the bond space currently, perhaps investors should put their faith in Chinese government bonds as opposed to US Treasuries, in the hope of reaping their reward. Neal Kimberley is a commentator on macroeconomics and financial markets