Worst May Be Over for Chinese Bonds as Swaps Signal Easing

  • Market expecting slower economy, bond demand revival: analyst
  • Government debt beginning to show value, says Income Partners

China’s derivatives market is flashing signals that the worst is over for the nation’s bonds.

One-year interest-rate swaps are trading near the biggest discount to the one-year sovereign bond yield since January 2016, suggesting that traders expect funding costs to ease. The case for a pause -- or a slowing at least -- in a central bank deleveraging drive is receiving a boost from signs that the economy is beginning to feel the pain. The yield on the benchmark 10-year government debt dropped by the most since April 25 on Wednesday.

“History has shown that the spread between cash bonds and derivatives reflects the market expectation of policy direction,” said Li Haitao, head of fixed-income trading at Huafu Securities Co. “The rate swaps market has captured the change since last month in regulators’ attitude toward a less hawkish stance.”

China has stepped up efforts to stave off excessive concern, with the central bank-run Financial News saying that the “abnormal market swings” of June 2013 won’t happen again -- a reference to a record cash crunch four years ago. The report, and other supportive articles run by the Xinhua News Agency, follows comments in the People’s Bank of China quarterly monetary policy report that the nation will maintain a stable supply of liquidity.

Here are three charts to illustrate the case for a bond market recovery, and one that flags funding costs are still at multi-year highs:

The 12-month interest-rate swap has declined 32 basis points to 3.55 percent on Wednesday since reaching an almost three-year high in May. The contract, which locks in the seven-day repurchase rate for one year, is now trading lower than the similar maturity sovereign bond yield of 3.61 percent. The last few times this happened, a debt rally followed.

“The diversion shows that people are expecting a slower economy and revival in demand for debt investments,” said Shi Lei, chairman of investment consultant Attractor Adviser, who’s been following the Chinese market for more than a dozen years. “The yields in the cash market will head south in August, or September latest.”

Banks’ pain could turn out to be bonds’ gain. China’s deleveraging efforts are cutting into banks’ profit margins, with the cost of borrowing rising beyond the rate they charge customers for loans. The one-year Shanghai Interbank Offered Rate has exceeded the Loan Prime Rate, the first time this has happened since the latter was introduced in 2013. This reduces the incentive for banks to lend and risks hurting the economy. The PBOC is sticking to a “prudent and neutral” monetary policy as it aims to ease market pressure, according to a commentary in the Financial News Wednesday.

“There is a chance that China’s economic data will turn weaker in the second half because of the recent credit tightening,” said Raymond Gui, Hong Kong-based senior portfolio manager at Income Partners Asset Management Ltd. “Chinese government bonds and high-grade debt are starting to show value, and hence we see an entry opportunity from a fundamental perspective.”

China’s bond yields are already beginning to show signs of moderating. The 10-year yield declined 11 basis points in the five days through Wednesday, the longest downward run since August. It has dropped 16 basis points since reaching a two-year high of 3.70 percent in early May. The benchmark yield tends to follow growth in the producer price index, which slowed for the third month in a row in May.

A cyclical slowdown in China over the second half of 2017 is inevitable as a price-driven recovery stalls, according to Raymond Yeung, chief Greater China economist at Australia & New Zealand Banking Group Ltd.

Data released earlier this month had China’s manufacturing gauge at the lowest level since October, while figures Wednesday showed fixed-asset investments missed estimates and edged lower from a month earlier.

The 50-day moving average of China’s benchmark seven-day money-market rate is now at the highest since early 2015, suggesting that any rally in bonds will be slowed by tight liquidity. Short-term borrowing costs have surged as part of the official deleveraging drive, pushing the one-year sovereign yield to four basis points higher than the 10-year yield.

The high funding costs will restrain any decline in long-term yields, China Securities Co. analysts led by Huang Wentao wrote in a June 12 note.

— With assistance by Helen Sun, Xize Kang, and Jing Zhao

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