Why China’s central bank is the ‘reliable boyfriend’ bond markets need

Bond investors have faced a flurry of confusing and sometimes misleading messages from Western central banks, creating a disconnect in expectations
In contrast, China’s central bank has been a paragon of restraint as it pursues financial stability above all other goals

Nicholas Spiro

Published: 6:45am, 12 Nov, 2021

Why you can trust SCMP

A mood of mistrust pervades global bond markets. Investors have been piling pressure on leading central banks in the past few months, calling on them to explain how they intend to prevent the surge in inflation from getting out of hand without endangering the recovery.

The signals from central banks have been confusing and, in some cases, misleading. This has resulted in a dangerously wide gap between bond investors’ expectations about the timing of interest rate increases and central banks’ forward guidance.

The disconnect is most apparent in Britain, where the Bank of England’s decision last week not to raise rates despite having strongly hinted that they could rise this year stunned investors.

The move sparked criticism that Britain’s central bank was once again behaving like an “unreliable boyfriend”. It was the same accusation levelled at it in 2014 when it flirted with – and then rejected – higher borrowing costs.

Other central banks, notably those in Australia and Canada, have also confounded investors. Their decisions are fuelling uncertainty about the severity of the threat posed by higher inflation and causing intense volatility in short-term government bonds.

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What are CPI and PPI?

Given the global nature of the sovereign debt market and the worldwide problems of rising inflation, the communication breakdown between central banks and investors has ricocheted across bond markets.

The challenges faced by the US Federal Reserve, which has gone to great lengths to convince markets that the reduction in its asset purchases is not a signal that rate increases are imminent, have become more acute. Markets expect the Fed to begin raising rates as soon as next September.

However, one central bank has proved adept at guiding market expectations. The People’s Bank of China (PBOC) has emerged as a bastion of stability and predictability amid the confusion over the conduct of monetary policy in Western economies.

To be sure, markets have worries about the wider policy regime in China. They are particularly concerned about the lack of any meaningful stimulus to help cushion the sharper-than-expected slowdown.

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China’s economy rose 7.9 per cent year on year in the second quarter of 2021

Given the severity of the simultaneous shocks hitting the economy – the energy crunch, the unsustainable “zero-Covid” strategy and, most alarmingly, the escalating credit worries in the all-important property sector – Chinese policymakers’ prioritising of financial stability over growth-supportive measures looks like an unduly austere approach.

Yet, investors have grown accustomed to the normalisation of monetary policy in China. Gone are the days when the PBOC could be relied on to unleash massive liquidity. Haunted by the excessive credit growth in the years following the 2008 global financial crisis, China’s central bank has eschewed across-the-board easing in favour of carefully calibrated loosening.

In bond markets, the PBOC’s message of stability and restraint has come through loud and clear. In a report published on November 4, JPMorgan noted that markets are pricing in a trivial 22-basis-point rise in the benchmark one-year loan prime rate by the end of next year. The consensus among economists is that the main rate will remain unchanged.

From an Asian perspective, the PBOC looks positively dovish. Markets anticipate proper rate-increasing cycles in India, South Korea and Malaysia, with benchmark rates expected to increase 174, 138 and 105 basis points respectively by the end of 2022.

Next move for China’s interest rates should be up, not down

Admittedly, there is less pressure on the PBOC to raise rates. The publication of data on US inflation on Tuesday showed that prices last month rose to a 31-year high of 6.2 per cent year on year. In China, while producer prices have soared, consumer prices rose by 1.5 per cent in October from a year earlier, held down by weak consumer spending.

Yet, other factors are more important in explaining why the PBOC is successful at managing market expectations.

First, Chinese monetary policy has effectively decoupled from its US counterpart. Chinese bonds, unlike those of other leading developing nations, are much less sensitive to movements in US Treasury yields. Not only does this make it easier for the PBOC to steer market rates, it makes China’s higher-yielding government bonds quite appealing from a portfolio diversification perspective.

Second, while the dramatic sell-off in China’s “junk” bonds has damaged sentiment, the combination of surging foreign inflows into the country’s government debt market and a huge trade surplus is boosting banks’ holdings of foreign currency. This makes China less vulnerable to a global shock, reducing pressure on the PBOC to ease policy more aggressively.

Third, China’s central bank no longer has a communication problem, having learned from its blunders following the surprise 2015 devaluation of the yuan. The PBOC’s messaging over the past several years has been consistent and coherent.

Although its policy stance might be overly restrictive, it cannot be accused of overcommunicating, arguably the biggest problem facing Western central banks right now. There have been no big surprises in Chinese monetary policy of late and bond investors do not anticipate a major policy error, partly because of the tools at the PBOC’s disposal to provide sufficient liquidity.

The credibility of central banks is being sorely tested. Given the severity of China’s slowdown, the PBOC is bound to come under pressure to provide more stimulus. That bond markets are not expecting a major shift in policy should make its job easier.

Nicholas Spiro is a partner at Lauressa Advisory