Something odd is going on in China. On one hand, the PBOC has been soaking up excess liquidity from the market like a drunken sailor, and after not conducting reverse repos for 10 consecutive days, it has reduced the excess liquidity level by 510bn yuan in the latest week as existing open market operations matured, and roughly half that in the week prior.
On the surface, this would suggest a sharp tightening in monetary conditions, and yet precisely the opposite is taking place: over the past week, instead of rising short-term rates – the traditional indicator of tighter conditions in China – yields on Chinese short-dated instruments have tumbled. Putting the move in context, 1Y yields have plunged nearly 20bps in the first week of 2018, the biggest weekly slide since June 2015.
In parallel, on Thursday the 7-Day repurchase rate slid to the lowest since April.
While some have provided theoretical explanations, nobody really knows what is going on. In fact, some such as Citi have put on the tinfoil hat and speculate that the PBOC is covertly adding tons of liquidity on the short-end of the curve, to wit:
It looks like the PBoC has been adding quite a lot of liquidity in the shorter end of the curve in recent days -with a variety of interbank rates softer, and the 1y CGB yield notably lower by 21bps YTD whereas 5s and 10s yields have stayed broadly flat.
Assuming that Citi is correct, it would explain many things, not least of all the stunning surge higher in Chinese, global and even US stocks. This is how Citi puts it:
Against that background, it is no surprise that equity markets have been so well supported and the SHPROP has exploded upward.
Finally, the bank puts the move in the context of declining Chinese producer price inflation, as well as the surging Yuan:
While it is always possible that early-year developments can be attributed to year-end positioning being adjusted, easier liquidity definitely provides some cushion for the PBoC against rising real rates if the PPI continues to fall, and the exchange rate continuing to show some modest appreciation.
Meanwhile, Bloomberg was quick to rain on China’s parade, first highlighting some other possible reasons for the plunge in short-end rates:
Relief was palpable in the market this week after typical year-end liquidity tightness passed and the central bank said it will let banks use reserves to meet funding needs during February’s week-long Lunar New Year holidays. The one-year government bond yield has plunged 17 basis points since markets re-opened in the new year, set for the biggest weekly slide since June 2015, when China slashed rates.
… then quickly nothing that despite the drop in short-end yield, the 10-year yield has kept climbing, causing the yield curve to steepen sharply.
That is not good, because as Bloomberg then explains, the failure of the 10-year yield to follow the short-end lower suggests traders are still bearish on the factors that made China one of the world’s worst-performing bond markets in 2017. Commodity prices are rising, the U.S. is still on a tightening path, and the People’s Bank of China has skipped cash injections for ten straight days, a sign it’s reluctant to ease funding conditions significantly.
“The PBOC’s maneuver shows on the short end, it’s guaranteeing that you won’t have any problems,” said James Yip, a Hong Kong-based money manager at Shenwan Hongyuan Asset Management. “If people are more upbeat cyclically, it means their expectations are more optimistic about the economy and inflation, which is a worry for the long end. Plus you still can’t see any loosening or resolution in the whole regulatory framework.”
True, the sharp steepening may be bad for bond market, but for now at least it is welcome news for stocks, and if Citi is right, the PBOC now has an explicit – and covert – mandate
But the bigger picture remains the same: China’s economic data have been mostly stead, if on a slowing glidepath, even as the BBG commodities index jumped to a 10-month high, increasing the risk of faster inflation. At the same time, the latest set of Federal Reserve minutes show gradual U.S. tightening is still on track, giving China some pressure to follow suit.
And in a sign curbing financial risks remains an official goal, policy makers tightened supervision of entrusted bond holdings to curtail leverage, Bloomberg News reported on Thursday.
Investors “are still very much worried about funding conditions before the Spring Festival and regulations, so they’ve concentrated their holdings in short-end ‘haven’ types,” Qin Han, a fixed-income analyst at Guotai Junan Securities Co., wrote in a note. “Although funding conditions are extremely loose, investors have been scared stiff.”
Of course, one wouldn’t know it from looking at stocks, either in China or the US, where daily records are now the norm. On the other hand, if this is nothing but more PBOC liquidity injections, then the party is about to end as soon as the Chinese central bank is forced to reverse its covert monetary policy, and soaks up liquidity from the short end, and risk assets, and reverts to more conventional monetary instruments, even as financial conditions around the globe continue to tighten…
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