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China Bonds in Worst Week in Two Years as Fed Adds to Stresses

Updated on
  • Yuan drop, outflows cited as reasons for negative sentiment
  • Reversal unlikely even in medium term, says CBA analyst

China’s sovereign bonds posted the biggest weekly decline in two years, reeling from the fallout of hawkish Federal Reserve comments, yuan depreciation pressures and waning liquidity.

The 10-year sovereign yield surged 25 basis points this week, the most since December 2014, to 3.35 percent on Friday. The one-year yield jumped 50 basis points, while the five-year rose 27 basis points. The yuan, which fell to an eight-year low, is heading for the biggest weekly decline in a month.

The debt market selloff caught investors by surprise, with Bocom International Holdings Co. flagging the risk of further declines and Commonwealth Bank of Australia saying it’s hard to see a reversal of fortunes even in the mid-term. While the Fed’s indications of quicker tightening fueled fears of faster fund outflows and ignited a record one-day yield jump Thursday, Chinese bonds have been under pressure in recent weeks from a government-driven effort to reduce leverage.

“Given capital outflows, the overall liquidity in the domestic market is volatile,” said Kun Shan, head of local market strategy in China at BNP Paribas SA in Shanghai. “It depends on how the People’s Bank of China will manage this, but the overall trend won’t change dramatically because we’re near year-end and it really depends on yuan depreciation.”

Policy makers shifted their focus in the second half of this year to reducing financial risks as economic growth stabilized, with PBOC Deputy Governor Yi Gang saying in early September the nation’s short-term goal is to lower leverage ratio growth. By steering money-market rates higher, the PBOC has forced a correction in the highly leveraged bond market, while home prices are showing signs of cooling amid property curbs.

While the PBOC has been using new lending tools and open-market operations to replenish liquidity, they haven’t been enough to offset persistent cash outflows. In the eight months through November, the outstanding balance in the monetary authority’s Medium-term Lending Facility increased by 1.4 trillion yuan ($201 billion), while the PBOC’s yuan positions, a gauge of capital flows, dropped by 1.6 trillion yuan. The nation’s foreign-exchange reserves fell by $69.1 billion in November, the most since January.

The finance ministry sold only 9.57 billion yuan ($1.38 billion) of 182-day bills in a planned 10 billion yuan sale on Friday. It also sold only 10.85 billion yuan of 91-day bills in a planned 12 billion yuan sale.

“Investors may wait on the sidelines and park their funds with short-tenor assets toward year-end,” said Frances Cheung, Hong Kong-based head of rates strategy for Asia ex-Japan at Societe Generale SA. “We see the 10-year government bond yield going back to a fair value 3.2 percent by mid next year as the U.S. Treasury yield has limited upside and so has domestic inflation.”

Bond futures recovered on Friday, with the contract on 10-year notes jumping 1.2 percent, a record in data going back to March 2015.

The PBOC injected funds into the market on a net basis using reverse-repurchase agreements for a third straight day on Friday. The authority advised lenders to offer long-term funds to non-bank institutions through window guidance, Caixin reported on Friday. Volatility in the money market have prompted securities firms and funds to sell their bond holdings as they have a less stable funding base.

Liquidity will remain tight through February and there will be no reprieve in the selloff, said Sue Trinh, head of Asia foreign-exchange strategy at RBC Capital Markets in Hong Kong.

— With assistance by Emma Dai, and Christine Harvey

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