Bond Bulls Curb Their Enthusiasm in China’s Leverage Crackdown

  • Central bank tweaks to money markets boosting funding costs
  • Sovereign debt yields seen not making new lows this year

China’s bond bulls are setting their sights lower these days.

Haitong Securities Co. and Shanghai Rationalstone Investment Management Co., which predicted last month that 10-year government yields would plumb new depths this year, now say the decade-low reached in August won’t be surpassed. Funding costs are inching up thanks to tweaks that China’s central bank is making in money markets, while officials are holding back from easing policy now so they have room to move after the Federal Reserve raises interest rates, the investors say.

The People’s Bank of China started using longer-term lending tools in late August for the first time in months, spurring speculation policy makers were seeking to curb leverage in the debt market. China’s bond market is poised for a 13th quarterly gain, a record winning streak, according to an index compiled by Bank of America Merrill Lynch. The debt pared gains over the past month as the PBOC’s changes coincided with a global bond selloff amid signs central banks in Europe and Japan were questioning the benefits of expanding stimulus.

“The changes in the money market are showing the most accommodative period is already behind, so we’re not going to see new lows for yields this year,” said Wang Ming, chief operating officer at Shanghai Yaozhi Asset Management LLP, which oversees 15 billion yuan ($2.2 billion) of fixed-income securities. “We see the inflection point for liquidity both domestically and globally.”

The benchmark 10-year sovereign yield has risen to 2.75 percent after falling to 2.64 percent on Aug. 15, the lowest level since Bloomberg started compiling ChinaBond data in 2006. The yield on government notes due August 2026 fell two basis points to 2.74 percent on Friday, according to National Interbank Funding Center prices.

China’s central bank started to use 14-day reverse-repurchase agreements to inject funds on Aug. 24, followed by one-month contracts three weeks later. That boosted the average cost of funds pumped into the financial system comparing with using only seven-day funds. The rally in Chinese debt increased demand for leverage to amplify returns, with transactions of overnight repo agreements climbing to a record 52.3 trillion yuan in August, compared with a monthly average of 31.8 trillion yuan last year.

Shanghai Rationalstone Chief Executive Officer Zhou Li, who predicted last month that the benchmark 10-year yield could touch 2 percent this year, is now more pessimistic.

“The use of 14-day and 28-day reverse repo contracts helped to raise the cost of funds, signaling the central bank’s reluctance to ease further ahead of a possible Fed interest-rate hike,” said Zhou, who’s been following China’s fixed-income market for more than 20 years. "It also reflects the PBOC’s intention to curb leverage in the bond market that could bring financial risks. Considering all these factors, bond yields probably won’t touch new lows this year.”

Twin Threat

The nation’s short-term goal is to slow rising leverage, PBOC Deputy Governor Yi Gang said in a television interview earlier this month. Federal Chair Janet Yellen made clear that the U.S. central bank intends to raise rates this year after delaying the decision at its meeting on Wednesday.

The bond rally faces the twin threat of a stabilizing economy that’s reducing the need for the PBOC to ease monetary policy, as well as the rising cost of short-term borrowing, according to Haitong, whose fixed-income research team was ranked No. 1 last year by the New Fortune Magazine last year. The brokerage last month said the 10-year yield on government bonds may drop to 2.5 percent this year.

No Easing

The government’s manufacturing gauge for August climbed to its highest since 2014, while reports this month showed that factory output, investment and retail sales all exceeded estimates. The central bank hasn’t cut benchmark interest rates in almost a year amid signs of a bubble in the nation’s housing market.

The average overnight repo rate this month is the highest since April 2015. It was at 2.13 percent as of 4:30 p.m. in Shanghai on Friday, according to weighted average prices from the National Interbank Funding Center. The cost of one-year interest-rate swaps, the fixed payment to receive the floating seven-day repo rate, climbed to 2.56 percent on Wednesday, the highest since June.

“The seven-day repo rate has been the floor for 10-year bonds since 2015, so if the PBOC doesn’t want to cut the interest rate offered in reverse repo operations, it will be difficult for the 10-year sovereign yield to breach 2.5 percent,” said Jiang, who leads Haitong’s team.

— With assistance by Helen Sun

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