South China Morning Post
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While most developed markets and Asian central banks have been tightening financial conditions, the People’s Bank of China has cut key interest rates and reserve requirement ratios for banks. Photo: Reuters
Opinion
Macroscope
by Marcella Chow
Macroscope
by Marcella Chow

As US government bonds surge, it’s a different story for China and Japan

  • Bonds yields have fallen in China and barely risen in Japan on looser monetary policy. But even the rest of Asia is growing less sensitive to the sway of Treasuries
Marcella Chow
Marcella Chow
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Since the expansive post-Covid-19 reopening, central banks across the globe have been grappling with inflation underpinned by both pent-up demand and supply disruptions. While we have witnessed arguably the most aggressive monetary tightening cycles since the Great Inflation of the 1970s, markets seem divided on whether the latest cycle of interest rate increases is reaching its conclusion.

Inflation is moving in the right direction but uncertainties around energy prices as a result of the conflict in the Middle East and the continued hawkish central bank messaging have prompted markets to price in a “prolonged higher for longer” scenario, particularly for the US Federal Reserve.
Against elevated inflationary price pressures, long-term US government bond yields have increased sharply, and have started to include higher “term premiums” – the compensation investors expect to bear for the risk of holding longer-term debt. Still, the risk regarding the direction of bond yields is somewhat balanced at this point, and contingent on the Fed’s near-term outlook.

Asian bond yields used to move in sync with US bond yields but the correlation has loosened over the years. The 12-month rolling correlation rate has fallen from 0.91 at the end of 2021 to 0.52 last month. This can be attributed in part to Asia’s financial sector being increasingly intermediated through the banking system rather than the capital markets.

Another possible reason is that the monetary tightening cycle in Asia is less assertive than in other regions such as Latin America. This decline in Asia’s sensitivity to US rates has been broadly positive for banks’ balance sheets.

But the narrative around bonds yields in China and Japan are a different story altogether.

While most developed markets and Asian central banks have tightened financial conditions over the past six to 12 months, a lacklustre Chinese economy – hindered by weakness in the property sector and sluggish private investments – has prompted the People’s Bank of China to cut key interest rates and the reserve requirement ratios for banks.
In Japan, while growth has been fairly resilient and inflation looks to have made a return after two decades of deflation, the Bank of Japan has maintained its accommodative stance on monetary policy. It does this by keeping short-term interest rates negative and continuing to cap bond yields – albeit adjusting to let the 10-year government bond yield rise up to 1 per cent.
These have led government bonds in China and Japan to behave very differently from Treasuries, their US counterpart. While the 10-year Treasury yield has risen by more than 3.33 percentage points since the end of 2021, China’s 10-year government bond yield has fallen by about 0.07 percentage points. Japan’s 10-year government bond has barely risen, at a restrained 0.8 percentage points and this was pretty much in lockstep with the relaxed yield cap.

But perhaps more importantly, the 10-year bond yield differentials for China and Japan relative to the US have widened by more than 3.4 percentage points and 2.5 percentage points respectively. This has led the Chinese yuan and Japanese yen to decline against the US dollar, by more than 12 per cent and 23 per cent respectively since the end of 2021.

For China, a lack of economic momentum and the less attractive rate differentials has led to capital flight concerns. For Japan, the cost of hedging and positive bond yields have fuelled speculation over local investors repatriating their foreign investments.

The growth differential between the United States and Asia has been key to capital flow movements. With US growth resiliency expected to dial back slightly and the Asian tech cycle likely to have bottomed out, the US-Asia growth differential is likely to move in favour of Asia next year.

Recession looms over US economy despite surprising GDP growth

And with US interest rates expected to stay high for longer as the Fed endeavours to bring inflation down to its 2 per cent target, it looks like the decline in long-term Treasury yields could be gradual. On the flip side, should the 10-year Treasury yield edge closer to 5 per cent, Asia’s decreased sensitivity could give its bonds somewhat of a price buffer.

Meanwhile, the US dollar is likely to remain resilient, particularly in the context of heightened geopolitical risk and weaker growth prospects for the euro zone. Asian currencies could thus experience further weakening pressure in the coming months.

While Asian central banks are likely to be done with their hiking cycle, they will not be in a hurry to cut policy interest rates given their concerns over foreign exchange weakness – as exemplified by the recent trend of forex market invention. This, in combination with broadening disinflationary pressures in Asia, should mean that Asian bond yields are unlikely to rise further in the near term, but could grind lower.

Marcella Chow is a global market strategist at J.P. Morgan Asset Management

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