China Bond Traders Are Betting on More Stimulus After Brexit

  • PBOC may cut reserve ratio as soon as July: StanChart, ANZ
  • The 10-year sovereign yield dropped most this year in June

Brexit may be bad news for China, but it’s improving a poor year for the country’s bond investors.

The 10-year government bond yield fell 14 basis points in June, the biggest decline this year, after Britain’s vote to leave the European Union spurred demand for haven assets. Before the shock decision added fuel to a rally in bond markets worldwide, Chinese yields had seen the only increase among similar-maturity sovereign debt in the world’s 15 biggest economies.

Expectations a plunging euro and rising political uncertainty in Europe will hurt demand for Chinese products is boosting speculation the People’s Bank of China will take steps to ease monetary policy. Australia & New Zealand Banking Group Ltd., Standard Chartered Plc and Commerzbank AG all say the nation will probably lower banks’ reserve requirements as soon as July, while one-year interest-rate swaps, a gauge of rate expectations, fell the most last month since April 2015.

"People have digested all the bad news and are now realizing they have been too pessimistic" about the bond market, said David Qu, an economist at ANZ in Shanghai. "After Brexit, there’s concern slower growth in the EU and U.K. will hit Chinese exports. As economic growth is still a key orientation for the central bank, it will take action."

Additional monetary easing would mark a departure from recent central bank policy, which has mostly relied on open-market operations to adjust funding conditions this year. China last cut its benchmark lending rate in October, while the reserve requirement ratio has been unchanged since February. A high-profile warning by the People’s Daily about the nation’s high levels of debt in May had damped hopes for more easing after credit surged by a record in the first quarter.

Qu predicts the yield will fall below 2.7 percent this year, which would put it near a record low reached in 2009. The yield on notes due May 2026 fell four basis points on Friday to 2.81 percent, National Interbank Funding Center prices show. That’s the lowest level for a benchmark security since March 16, according to ChinaBond data. Its gap with similar U.S. Treasuries widened to 1.39 percentage point, the most since August, as expectations the Federal Reserve will raise rates this year faded.

Some 15.6 percent of China’s exports are destined for the EU, while 2.6 percent go to the U.K., according to Bloomberg Intelligence. Based on historical relations, a one percentage point drop in the EU’s gross domestic product growth could take 0.2 percentage points off China’s GDP growth.

Flight to Quality

Fourteen of 22 respondents in a Bloomberg survey of investors and analysts said they are most interested in buying securities issued by the government and policy banks in the third quarter, compared with just four of 19 in a similar poll three months ago.

Bets on interest-rate cuts may be misguided because the central bank prefers using open-market operations to control the pace of loosening, said Hu Yifan, Hong Kong-based chief China economist at UBS Wealth Management. Easier borrowing conditions since late 2014 fueled rallies in stocks, bonds and property, creating potential bubbles, Hu said.

Still, Brexit has intensified other concerns. The yuan weakened 1 percent in its third straight month of declines as the U.K. vote drove funds into haven assets, fueling concern capital outflows would quicken again. An estimated $1 trillion left China last year as firms repaid their overseas debt and mainland investors bought foreign assets.

To replenish cash supply, the PBOC has lowered the amount major banks are required to hold as reserves to 17 percent from 20 percent at end-2014.

"Capital outflows are a structural phenomenon; it’s not a month or seasonal pattern," said Ding Shuang, head of greater China economic research at Standard Chartered in Hong Kong. "So there is reason to believe this is a kind of new normal and the liquidity lost will not come back any time soon. It’s better to provide long-term liquidity through RRR cuts."

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