China's Bond Market Rally Is Just About Over, Deutsche Bank Says

(Bloomberg) -- Even amid a global bond selloff, China’s debt has climbed since mid-January, riding the back of an abundance of domestic liquidity, a slowdown in issuance and some flight-to-safety amid concerns about trade tensions. But that bid is about to end, Deutsche Bank AG says.

"Chinese government bonds have become relatively expensive," Liu Linan, Deutsche Bank’s Hong Kong-based greater China rates and currency strategist, said in an interview this week. "We could see some correction in the second quarter."

China's Bond Market Rally Is Just About Over, Deutsche Bank Says

Yields on China’s 10-year government bonds will jump to as high as 4.2 percent by year-end, the highest since September 2014, according to Linan, who has worked as an analyst of emerging markets for about 18 years. Last quarter, they dropped the most since 2015.

Behind the rationale for Deutsche Bank’s bearish call:

  • The People’s Bank of China is likely to hike money-market rates by as much as 40 basis points the rest of this year.
  • New rules on asset management and banks’ liquidity management will reduce demand for bonds from leveraged investors; smaller banks may shrink their balance sheets, leading to scaled-back exposure to bonds and other assets.
  • Debt issuance is set to climb after the national legislature’s approval of the annual budget. Net government-debt supply will increase 17 percent, to 3.73 trillion yuan ($590 billion), fueled by special-project bonds designed to reduce leverage among local authorities while sustaining public construction, Deutsche Bank estimated last month.

The upshot: unless a full trade war breaks out and darkens the global economic outlook, the main theme is likely to remain one of interest-rate normalization, according to Liu. She sees the PBOC following the Fed in boosting market interest rates, though by less magnitude.

"The China-U.S. long-term interest-rate differential will stabilize around its 10-year average of 100 basis points," Liu said. The gap is slightly higher than 1 percentage point today.

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