Jiang Chao of Haitong Securities says the latest upset on the Chinese bond market is the result of overreaction to a number of key economic drivers.
China’s bond market has faltered since the start of October, with the 10-year sovereign bond yield rising 31 basis points from the end of September to hit 3.92% on 30 October, for its highest level since October 2014, and ahead of the historic average of 3.6%.
Jiang Chao, chief economist of Haitong Securities, sees three key factor behind the dramatic adjustment on China’s bond market this month, with the first being concern over economic fundamentals.
On 16 October Zhou Xiaochuan said at a G30 summit that China’s GDP could see growth of 7% in the second half, which would be ahead of market expectations and serve to push bond yields higher.
Domestic analysts have also started to see inflation rising further in 2018, to around 2.5 – 3%.
A second factor undermining Chinese bonds has been concern over the possibility of tightened regulation, and in particular increased scrutiny of interbank lending next year, which could drive down interbank debt as a percentage of total debts to 25% from 33% at present.
The third and final factor has been the weak performance of the US debt market, after Q3 growth came in ahead of expectations at 3%, and the Federal Reserve began shrinking its balance sheet as well as flagged further rate hikes.
This has already pushed yields on 10-year US Treasuries to 2.42%, for a 30 basis point increase compared to the low tapped at the start of September.
Jiang Chao believes that the response of the Chinese bond market has been excessive, however, due to fundamentals pointing to weakening economic performance ahead.
Q3 GDP growth fell to 6.8%, for the first slowdown since the Chinese economy’s latest rebound cycle, while industrial growth fell to 6.3% from 6.6% in Q2.
Q3 manufacturing investment growth has fallen, while September real estate sales growth has entered negative territory, which will drag on real estate investment.
Appreciation of the Chinese yuan will have an adverse impact upon exports, while an ongoing slowdown in growth of finished goods inventories indicates that the inventory cycle has reached its tail end.
When it comes to inflation, Jiang Chao points out that the latest PPI rebound was due to support from downstream demand, and that if downstream demand continues to ease, there is a strong likelihood of a PPI slowdown.
Internationally PPI remains high while CPI is ailing, because the current global rebound is due to monetary loosening, which is impact asset prices most, yet is doing little to benefit whose who lack assets, and thus failing to drive marked increases to aggregate demand.
When it comes to the impact of overseas markets, Jiang points out that the average China-US yield spread has been 120 basis points since the start of the decade, peaking at 170 basis points.
The yield spread is now 150 basis points, approaching a historic peak, indicating that the conditions are sufficient for an adjustment.
“Looking at these factor, the short-term bond market has already made marked and excessive adjustments,” said Jiang. “We believe that 10 year sovereign bond yields at above 3.6% possess long-term allocation value.”
Jiang nonetheless remains concerned about the potential impact of tightened regulation, as the central government continues to drive its deleveraging campaign and pursue potentially painful short-term economic adjustments.
“The 19th National CCP Congress report said that the future economic growth model must transition from high-speed growth to high-quality growth, and improve the twin pillars of the adjustment framework, monetary policy and macro-prudential policy,” said Jiang.
“This means that in this new era we will no longer re-tread the old path of monetary watering – maintaining neutral monetary policy and strengthened financial regulation will be the predominant trend.”
When it comes to the debt structure of banks, as of September 2017 interbank debt was approximately 28.6 trillion yuan, accounting for 12% of total debt. This figure rises to 15% when 8 trillion yuan in interbank CD’s are taken into account.
Looking at data from the mid-year reports of listed banks, out of 34 listed banks seven had interbank debt to total debt ratios in excess of a third, while 21 had ratios in excess of a quarter.
Concerns about the high level of interbank lending has prompted the authorities to tighten regulatory scrutiny, with the People’s Bank of China slated to include interbank CD’s in macro-prudential assessments next year for lenders with assets in excess of 500 billion yuan.
Heightened regulatory scrutiny has already triggered an across-the-board shrinking in traditional forms of interbank lending, yet an ongoing expansion in interbank CD’s.
“If interbank CD regulatory is comprehensively strengthened, then this will remove a major source of bank funds, and on the flip side means that bank assets must undergo corresponding shrinkage,” said Jiang.
“Bank assets consist primarily of several major categories include sovereign bonds, corporate bonds and loans, of which loans have the lowest liquidity, corporate bonds have weak liquidity, and sovereign bonds are the easiest to sell.
“For this reason, strengthening of regulation could be a shock for sovereign bond yields.”
