China Yield Curve Flattens as PBOC Seen Resisting Rate Cuts

  • Yield gap between 1-year, 20-year bonds is smallest since 2015
  • Economic growth concern boosting longer-dated maturities

In China’s bond market, the longer the better.

The difference between yields on China’s one- and 20-year government bonds, a measure known as the yield curve, has narrowed to the least since April 2015. Declines in shorter-term yields are being capped by expectations the central bank will hold off from cutting borrowing costs, while concerns the economic outlook will worsen is boosting longer-dated maturities.

The flattening curve reflects the dilemma facing the People’s Bank of China. Lower interest rates and the central bank risks fueling asset bubbles as well as increasing pressure on the currency to weaken, thereby accelerating outflows. Keep policy on hold and the economic slowdown could deepen further. In the past 12 months, the country has seen markets from stocks to commodities and property overheat, while the latest crop of data show no recovery in sight for the world’s second-largest economy.

"The situation now is that monetary policy is very cautious and hasn’t changed for a long time, but everyone’s becoming more pessimistic about the economy," said Chen Kang, a fixed-income analyst at SWS Research Co. in Shanghai, who predicts the central bank won’t cut borrowing costs until next year.

Chinese government bonds are now headed for their third year of gains. The benchmark 20-year yield rose one basis point to 3.07 percent on Wednesday, while the one-year yield was little changed at 2.10 percent. The spread between the securities was 97 basis points, after reaching a 16-month low of 90 basis points on Monday. The current 10-year yield fell one basis point to close at 2.69 percent on Thursday.

China will keep its benchmark one-year lending rate at 4.35 percent for the rest of this year, according to 14 of 27 economists surveyed by Bloomberg. The rate was last lowered in October. The reserve requirement ratio for major banks has been held at 17 percent since February. Economic growth will slow to a seven-year low of 6.5 percent this quarter and next, compared with 6.7 percent in the April-June period, the median estimates in a Bloomberg survey of analysts show.

Since the current easing cycle began in late 2014, the economy has struggled to stage a recovery, suggesting that looser funding conditions have fueled speculative activity rather than corporate investment. In the wake of the boom-bust in the equities and commodity futures markets, China’s top leaders last month pledged to curb asset bubbles in a Politburo meeting led by President Xi Jinping.

Multiple Tools

"Policy makers will ask themselves whether rate cuts can achieve the effects they want and whether the economy will really improve," said Li Liuyang, an analyst at Bank of Tokyo-Mitsubishi UFJ (China) Ltd. in Shanghai. "If the economy isn’t doing better and other problems have been worsened by easing, then the policy has failed."

The central bank is signaling it will use liquidity measures rather than broad easing moves. A cut to lenders’ reserve requirements would add too much liquidity to the financial system and lead to yuan depreciation expectations, PBOC said this month. The monetary authority said it will use multiple tools to maintain reasonable growth in credit and aggregate financing.

For a look at the PBOC’s increased policy communication, click here.

Faced with a dearth of attractive investment options domestically, and tight controls on overseas purchases, companies are looking for ways to improve returns over holding cash. M1, the total of cash, checks and demand deposits, rose at the quickest pace in six years in July.

In such an environment, government debt will become even more appealing, Li said.

"When liquidity is ample and economic and corporate performance aren’t good, people will pick fixed income, low-risk assets for carry," he said.

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