China's Bond Strategists Brace for 10-Year Yields Rising to 4%

(Bloomberg) -- China’s sovereign bonds may drop further as the nation extends its campaign against excessive borrowing, driving 10-year yields to 4 percent and beyond, according to analysts and economists.

The yield on debt due in a decade extended its advance past 3.8 percent on Thursday after rising by the most in five months in the previous session amid a drop in U.S. Treasuries and a halt in central bank cash injections. There was also speculation that authorities may lower a cap on interbank liabilities, which the central bank addressed via a Xinhua report and said was untrue.

“The market is very fragile, and hence it is more likely to be moved by negative news,” China Merchants Securities Co. analysts led by Xu Hanfei wrote in a note Thursday. “As the 10-year sovereign yield breaks past 3.6 percent, technically it’s likely to trend upward to 4.1 percent.”

Chinese bonds have come under pressure this year amid the deleveraging campaign and signs of economic expansion. Losses accelerated last week after People’s Bank of China Governor Zhou Xiaochuan voiced concern about high borrowing levels and signaled that growth could beat expectations.

Regulatory tightening will continue, according to a Huachuang Securities Co. research note that said it isn’t yet time for “bottom fishing.” Yields will remain at high levels unless there are signs of an economic hard landing, Shenwan Hongyuan Group Co. analysts wrote in another note, adding that the 10-year yield could top out at 4 percent.

China's Bond Strategists Brace for 10-Year Yields Rising to 4%

The pace of declines has come as a surprise, with a survey of market participants conducted late last month predicting that the 10-year yield would drop to 3.59 percent at the end of the fourth quarter. On Thursday, the yield ended little changed at 3.79 percent, while the five-year yield added one basis point to 3.82 percent.

China Merchants Securities said in its Thursday note that another likely scenario is that yields stay range-bound between 3.8 percent and 4 percent as traders digest bad news. A Haitong Securities Co. report suggested that the market is already oversold, and that yields above 3.6 percent offer longer-term allocation opportunities.

Inflation Risk

Bond bears will also have to watch for the risk of faster inflation. While the consumer price index has remained subdued, with the latest reading coming in at 1.6 percent, core inflation -- which strips out food and energy prices - is the highest in six years at 2.3 percent. Consumer price growth is likely to quicken as the economy picks up strength, according to a report by Diana Choyleva, chief economist at Enodo Economics Ltd.

The PBOC may boost borrowing costs in open-market operations before or after a potential U.S. rate increase at the end of the year, said Ming Ming, head of fixed-income research at Citic Securities Co., China’s biggest brokerage. He added that the government could roll out more deleveraging measures by the end of this year.

“There’s room for the yields to climb even higher next year," he said. "That would be driven by more interest-rate increases by the Federal Reserve, and higher inflation in China and other economies."

©2017 Bloomberg L.P.