China’s Bonds Are Near Pressure Points as Liquidity Tightens

(Bloomberg) -- A much-anticipated selloff in China’s bond market, the world’s second largest, may not have materialized yet, but it is on its way if key indicators are any guide.

Producer prices are surging, activity gauges are on the rise and foreign bond buying has ground to a halt. What’s more, swap markets signal tighter liquidity.

All of this spells higher bond yields. Traders who had been bracing for a supply deluge in April that would have hurt China’s bond markets now face the risk of a crunch for yields this month.

Here are four charts that show how the pressure is building:

Li Keqiang Index

China’s bond market has a habit of lagging behind economic indicators and an alternative gauge based on Premier Li Keqiang’s insights shows how much catching up may lie in store.

The index of bank loans, electricity production and rail freight volume has popped to the highest levels since 2010. The move is particularly notable given how closely the gauge correlates with the nation’s five-year non-deliverable interest rate swap, pointing to higher rates in the near term.

Producer Prices Spike

Producer prices, which have demonstrated a stronger link to Chinese government bond yields than consumer prices, are running red hot. While the surge is due in part to the low base effect from last year, there is still room for acceleration given the sharp increases in the cost of commodity inputs for the nation’s manufacturers. The next installment for the data is due on May 11.

Global Demand

Foreign buying of Chinese bonds took a breather in March, according to the most recent data from ChinaBond. With global funds trimming holdings by 16.5 billion yuan ($2.5 billion), the drop-off in demand suggests high yields may be in order to entice buyers back.

The spread between China’s 10-year bond and similar maturity Treasuries has narrowed to around 160 basis points, from a record of more than 250 basis points in November. China’s 10-year yield closed at 3.15% on Thursday.

The slower-than-expected inclusion in FTSE Russell’s flagship global bond index -- over three years instead of 12 months -- reinforces this over the short term.

Quiet Shift

Short-dated interest rate markets in China are starting to taking notice, and they’re pointing to tighter liquidity coming soon.

The current three-month swap sits around 2.31%, though one that begins in three months is 12 basis points higher. This shows markets are getting ready for less liquidity, though this hasn’t reverberated out the yield curve yet.

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