Zhou on High Alert Prompts Swaps PBOC Rise Signal

China’s swap market is signaling interest-rate increases for the first time since 2011 after inflation accelerated to a 10-month high and the housing market defied government cooling efforts.

Two-year contracts that exchange the People’s Bank of China’s 3 percent savings benchmark for a fixed payment rose eight basis points this month to 3.03 percent, data compiled by Bloomberg show. The swap had been lower than the one-year PBOC deposit rate for 16 months. Of the 27 economists surveyed this month by Bloomberg, 13 predicted higher rates in 2013, with Credit Agricole CIB, Daiwa Capital Markets and Nomura Holdings Inc. forecasting two increases.

PBOC Governor Zhou Xiaochuan said on March 13 the government should be on “high alert” after consumer prices jumped a more-than-forecast 3.2 percent in February. Data last week showed new home prices last month posted the broadest advance since December 2011. China’s 10-year bond yield is 38 basis points higher than inflation, compared with a similar U.S. real yield of minus 8 basis points.

“The rising inflation trend and upward pressure on home prices will continue, forcing the central bank to tighten,” said Dariusz Kowalczyk, senior economist and strategist with Credit Agricole in Hong Kong. “Main lending rates will be hiked to reduce inflation expectations.”

Inflation will probably quicken to 4 percent in the second half, a level that will “really concern” the central bank, said Kowalczyk, who accurately predicted the February consumer-price gain. He forecasts two deposit rate increases after June to 3.5 percent to protect returns on savings.

Building Pressure

The central bank lowered its benchmark savings rate twice by a quarter of a percentage point in 2012 and swap traders were betting in July there would be a further four reductions within a year. The two-year deposit-rate swap reached as low as 2.46 percent on July 25. Buyers of the contract receive the current deposit rate for one year, after which the floating payment is reset for the second year at the prevailing rate.

Benchmark borrowing costs are all above returns on deposits. The yield on the 3.52 percent sovereign notes due February 2023 dropped two basis points last week to 3.57 percent, according to the Interbank Funding Center. The one-year interest-rate swap, the fixed cost needed to receive the floating seven-day repurchase rate, fell one basis point to 3.28 percent, data compiled by Bloomberg show.

The PBOC drained 47 billion yuan ($7.6 billion) from the financial system last week through repurchase operations, bringing total net withdrawals to 1 trillion yuan in the past five weeks.

Food Prices

Living-cost indicators were distorted by a weeklong holiday that ended Feb. 15. China’s February inflation was driven in part by a 6 percent gain in food prices, the fastest pace in nine months. Non-food prices gained 1.9 percent, the most in 14 months, the statistics bureau reported on March 9.

“Food-price increases are largely driven by the Chinese Lunar New Year holiday, while the accelerated gain in non-food items indicates inflation is becoming broad-based and pressure is building,” said Zhang Zhiwei, chief China economist at Nomura in Hong Kong.

The consumer price index may gain 3.4 percent in the third quarter before climbing 3.6 percent in the final three months of 2013, according to the median forecasts in a Bloomberg survey of economists between March 15 and March 20. The government set an annual inflation goal of 3.5 percent at the start of this year’s National People’s Congress, down from last year’s target of 4 percent.

Rate Reductions

Zhou, reappointed this month as PBOC governor, said on March 13 that monetary policy is “no longer relaxed” and is “relatively neutral.” Interest rates will probably remain unchanged in the first half while an increase in the second half is possible, Song Guoqing, an academic adviser to the central bank, said on March 19 at a forum in Hong Kong.

A PBOC quarterly survey released that day showed more Chinese residents are finding property prices too high and “hard to accept.” Statistics bureau data last week showed new-home prices climbed in 62 of 70 cities monitored by the government in February.

The nation is still dealing with the fallout from 17.6 trillion yuan of stimulus loans that flooded the economy between 2009 and 2010 to help it withstand the global financial crisis. Authorities this month ordered stricter enforcement of taxes on house sales, along with higher down payments and interest rates for second-home mortgages in cities with “excessively fast” price gains.

Asset-Price Bubbles

“Zhou is shifting the monetary policy from loose to neutral to fend off the inflation and asset-price bubbles,” said Shen Jianguang, chief Asia economist at Mizuho Securities Asia Ltd. in Hong Kong. “But a rate hike now will be considered too hawkish as the central bank is aware that the economic recovery is not in a solid foundation yet.”

Data this month showed Chinese retail sales and industrial output had the weakest combined start to a year since 2009 while new local-currency loans were lower than forecast in February. Concern the economic rebound is losing steam may have eased after the preliminary reading of a private Purchasing Managers’ Index released on March 21 climbed to 51.7 this month, signaling faster expansion in manufacturing.

China’s economy expanded 7.9 percent in the final three months of last year, ending a seven-quarter deceleration. Growth may accelerate to 8.1 percent this quarter before reaching 8.2 percent in each of the next two quarters, according to the Bloomberg surveys.

Rate Outlook

Mizuho’s Shen now sees the central bank increasing the deposit rate by 25 basis points, or 0.25 percentage point, in the fourth quarter, after last predicting in February that the rate will stay unchanged at 3 percent this year. He joins 12 other economists in forecasting higher rates in this month’s survey, up from nine out of 23 economists in December.

The cost of insuring China’s debt against non-payment with credit-default swaps rose seven basis points to 68 basis points last week, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market. The yuan rose 0.02 percent last week to close at 6.2122 per dollar in Shanghai, prices from China Foreign Exchange Trade System show. It touched 6.2095 today, the strongest level since 1993.

Expectations for faster inflation are driving State Street Global Advisors, which manages around $2 trillion, to underweight Chinese sovereign bonds.

“At this point in time, we wouldn’t be overweight Chinese yuan bonds since economic growth is expected to be higher than last year and inflation to rise further,” Ng Kheng Siang, Singapore-based head of Asia-Pacific fixed income at State Street, said in an interview on March 20.

— With assistance by Lifei Zheng

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