China's Unexpected Bond Rally Has Room to Run, Charts Show

(Bloomberg) -- A surprise rally in Chinese bonds is picking up steam, supported by uncertainty over trade negotiations with the U.S., easing liquidity and falling commodity prices.

Those factors have already combined to help drive the yield on benchmark 10-year sovereign notes to the lowest since October. This wasn’t expected to happen. At the start of the year, investors predicted Beijing’s regulatory tightening and deleveraging campaign would extend a debt market rout. Two months later, analysts thought a lack of liquidity would upend the rally.

Data released Friday indicated signs of a slowdown in March, with aggregate financing missing estimates and a seasonal drop in exports leaving a rare trade deficit, supporting demand for haven assets.

The following charts show why the rally may continue:

China's Unexpected Bond Rally Has Room to Run, Charts Show

China International Capital Corp., top-rated for fixed income research in last year’s New Fortune competition, said yields may have already tested the highs for this cycle in January.

In March, the benchmark 10-year government bond yield had its biggest monthly drop since June 2016, breaching its long-term moving average. This technical pattern usually suggests room for further declines over the next few months.

China's Unexpected Bond Rally Has Room to Run, Charts Show

Growth in China’s factory-gate prices tends to have a stronger positive correlation with long-term bond yields than consumer inflation. As commodity prices, including steel and copper, trend lower on expectations of an economic slowdown, the bond market isn’t worried about inflation. And the spillover impact of higher tariffs on prices is still months away.

If the central bank is comfortable with liquidity levels, there should be further downside for yields, said Sun Binbin, who leads bond research at Tianfeng Securities Co. “The central bank may prefer at this stage to stay put, given the U.S.-China trade dispute, and watch how things will develop.”

China's Unexpected Bond Rally Has Room to Run, Charts Show

The cost of one-year interest-rate swaps, which reflects market expectations for the benchmark seven-day repurchase rate over a year, is at the lowest since January 2017, indicating money-market traders aren’t pricing in any further liquidity tightening. With funding costs ranging from overnight to three months sliding, some investors have leveraged up their bond investments.

Li Liuyang, Shanghai-based analyst at China Merchants Bank Co., said yields are still very attractive for long-term investors.

China's Unexpected Bond Rally Has Room to Run, Charts Show

A stall in the advance of 10-year Treasury yields offers external support. Some analysts use the gap between benchmark Chinese and U.S. government debt to gauge capital outflow pressure, which in turn affects the exchange rate. As that’s stayed largely stable for the past two months, it’s been less urgent for China’s central bank to step up tightening along with the Federal Reserve.

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