Something strange is taking place in China, and we are not talking about the largely optical, mostly irrelevant first downgrade of China by Moody’s since 1989 (which still managed to unleash diplomatic hell in Beijing), and in which the rating agency simply admitted what everyone else already knew about the 300% debt/GDP economy.
The bigger issue, as we noted previously, is that both the short-term…
and conventional Chinese funding market appears to be breaking…
… because as of this week, not only has the one-year Shanghai Interbank Offered Rate, or SHIBOR, exceeded the Loan Prime Rate for the first time ever, meaning Chinese banks’ cost of borrowing is now above the rate they charge customers, but the Chinese government bond yield curve has inverted in not just one, but two places, with both the 3s5s and the 7s10s negative.
The question everyone wants answered is why. One attempt at just that, came today from UBS which first give the blow by blow of how we got there:
As market concerns about financial regulation continued in the first half of May, bond yields kept rising, with the 10-year CGB yield reaching 3.69% on 10 May. The People’s Bank of China (PBoC) renewed MLFs and increased net liquidity injection through OMOs. April economic data, such as FAI released by NBS, came in weaker than market expectations. More importantly, there were media reports that the China Banking Regulatory Commission (CBRC) showed a soft tone in requirements for banks to reach standards. Besides, the central bank’s statement on strengthening coordination in financial regulations eased market concerns about financial regulation.
As a result of these factors, the back end of the yield curve declined while the front end to continued rising moderately. According to Chinabond yield curves, as of 19 May 2017, 1-year, 5-year and 10-year CGB yields were 3.48%, 3.68% and 3.63%, respectively, up 9bp, 20bp and 7bp compared with 5 May 2017. Yields of 1-year, 5-year and 10-year policy financial bonds (CFBs; we use the bonds issued by the Export and Import Bank of China as examples) were 4.11%, 4.45% and 4.51%, respectively, up 21bp, 10bp and 6bp compared with 5 May 2017.
UBS notes that from the historical data of term spreads, we can see that inversion of 7-year and 10-year has happened more often, which could be attributed to better liquidity in the secondary market for 10-year bonds, but the recent greater than 10bp spread between 7-year and 10-year yields is still the first time that has happened over the past few years. The inverted 3s/10s and 5s/10s curve is also rare to see.
And while liquidity may be a factor, UBS concedes that liquidity gaps have always existed and may not be the main reason for the recent curve inversion. As such, the Swiss bank admits that “we need to consider some other factors.“
Below are some of the incremental factors besides liquidity:
- In terms of CGB issuance in the primary market, auction results in May showed that auction rates were all higher than market expectations, except for the 50-year CGB auction, which came in lower than the market’s expectation. Also, the spread between auction results and market expectations was larger for the less liquid tenors.
- That indicates that during weak market sentiment, a negative feedback loop formed between the primary market and secondary market. Besides, from an allocation demand perspective, insurance companies have shown increased demand for CGBs in recent months, in addition to banks, the major buyers of CGBs, which may provide support to long-tenor bonds.
More importantly, however, UBS notes that the inverted curve also reflects a contradiction between market expectations on policies and economic fundamentals.
On one hand, the slowdown of economic growth may prevent the back end of the yield curve from further going up. On the other hand, financial institutions’ funding costs have kept rising but the financing costs for the real economy measured by loan rates have not risen that much. And investors can hardly expect the monetary policy to ease in the current circumstances.
- We think the rise in financial institutions’ funding costs shows their intention to maintain the current asset/liability scale. From this perspective, the deleveraging process may continue for a longer period, while the change in economic fundamentals has not been enough to trigger a reversal of the monetary policy tone. We think in the short term, the yield curve is more likely to repair by having the back end go up again when the gap between market expectations and implementation of financial regulations appears again. Among long-tenor CGBs, the spread between 7-year and 10-year yields is quite large, which has made the relative value of 7-year CGBs rise much higher, in our view. We think when market sentiment calms temporarily, the yield of 7-year CGBs may adjust downward and provide a tactical trading opportunity. However, we expect the 10-year CGB yield to fluctuate at a high level, with a short-term cap around 3.7-3.8%. Although economic fundamentals may put some limit on the rise of the 10-year level, we don’t think there is much room for downside adjustment. Over a longer period, considering the progress of deleveraging, we think investors still need to pay attention to the renewal of banks’ funds that are under management of non-bank financial institutions in H2.
- Regarding the front end of the yield curve, although we think room for money market rates to go lower is limited in the short term, market expectations about liquidity conditions could stabilize, given PBoC’s recent tone, and that may create room for the front end of the CGB curve to go a bit lower. Over a longer period, we think if a more apparent economic slowdown happens in H2 and forces monetary policy to adjust, a larger opportunity for the front end to move down may appear.
The above not only why the CGB curve is inverted, but also why SHIBOR1Y is now above the LPR.
And while that may answer why both the CGB and the short-term funding yield curves are inverted, another, just as pressing question emerges: assuming UBS is right, and these yield oddities are merely “contradictions” between market reality and hopes, what happens when this divergence between fundamentals and expectations converges, and more importantly, what will such a mean reversion look like for China’s already bizarrely trading financial assets.
via http://ift.tt/2rBRvkv Tyler Durden