China’s Bond Sell-Off Won't Signal a Global Bear Market

(Bloomberg View) -- The unrelenting sell-off in China’s $9 trillion onshore bond market last year caused deep angst among investors. That performance is far from enticing as the country aims to further open up this market, the world's third largest, through initiatives such as the Bond Connect program. For now, foreign investors account for less than 2 percent of the onshore market, though it is likely to be included in major bond indexes in 2018. If that happens, foreigners' exposure may become mandatory.

So does this sell-off signal an investment opportunity? The answer is not yet, but things are starting to look more interesting. But neither is this sell-off the harbinger of a global bond bear market. It is primarily driven by financial deleveraging. The global bond bear market would start with signs of rising inflation pressure and hastened tightening from major central banks. So far, neither has occurred.

The sell-off started in late October 2016 (Chart 1), and gradually spread to offshore markets. The contagion was triggered when issuers compared cheaper funding costs overseas with interest-rate spikes at home and naturally switched to issuing bonds in foreign currencies. To calm the offshore market and establish benchmarks for the offshore corporate bond market, China introduced its first issue of $2 billion of five- and 10-year dollar bonds in October 2017.

China’s Bond Sell-Off Won't Signal a Global Bear Market

The sell-off included all issuer types: government bonds, policy bank bonds and corporate bonds, whose yields widened by 90 basis points, 115 basis points and 107 basis points (Chart 2).

China’s Bond Sell-Off Won't Signal a Global Bear Market

Two-year bonds were hit worse more than the 10-year securities with a flattening of the yield curve (Chart 3). This is driven more by liquidity and technical issues related to market demand and doesn't reflect recession or inflation expectations.

China’s Bond Sell-Off Won't Signal a Global Bear Market

The real yield differential between the China 10-year and the U.S. 10-year has reached a historical high within the past decade (Chart 4). This should justify more renminbi appreciation.

China’s Bond Sell-Off Won't Signal a Global Bear Market

What were the drivers of the sell-off?

Despite rating downgrades, China’s five-year CDS spread has tightened from 120 basis points at the beginning of 2017 to 50 basis points as of Dec. 31. (Chart 5). So this indicates the bond sell-off is not caused by concern over China’s sovereign health.

China’s Bond Sell-Off Won't Signal a Global Bear Market

There are multiple reasons for the sell-off:

  • Solid economic growth in China in 2017 has surprised the market. The country's reflation effort starting at the end of 2015 worked well, with PPI jumping to 5.8 percent from negative 6 percent; core CPI reached 2.3 percent. Future inflationary pressure also added to the anxiety in the bond market.
  • Against a backdrop of strong global expansion, China aimed to shift its focus to financial stability and reining in runaway credit via financial deleveraging and regulatory tightening. The prevention of financial risk was and continued to be the priority. The government has been cracking down on the sloshing of credit within the financial system, off balance-sheet bank lending and wealth management products. In addition, officials have been tightening the regulatory system regarding the asset-management industry and local government debt.
  • Despite the financial deleveraging, Chinese policy makers have avoided hiking benchmark rates for fear of sending too strong a signal and jolting the market. In the meantime, the People's Bank of China has been conducting frequent liquidity injections. In addition, open-market operations were used to squeeze interbank lending through hiking short-to-medium market lending rates three times in 2017. Market rates such as the seven-day repo and Shanghai Interbank Offered Rate, or Shibor, responded by going up.
  • As commercial banks are the dominant buyers of Chinese government bonds, higher bank funding rates resulted in less demand for these securities and even triggered sales.
  • Rising U.S. Treasury yields and multiple Fed rate hikes also contributed.

So why isn't this sell-off creating a buying opportunity for investors? China’s monetary policy will stay the course in 2018 with continuous financial deleveraging. It will continue to be “prudent and neutral,” even as open market lending rates rise, along with liquidity injections. Investors should closely monitor money-market rates to assess levels of funding stress. There is always a risk that policy makers are overconfident about growth momentum, which could lead to overtightening. The gap between market rates and benchmark rates is also worth noting as they can’t go too wide; one of them will have to adjust. Global central bank policies are also critical for China’s policy makers. The PBOC will react to what the Fed, European Central Bank and Bank of Japan do.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tracy Chen is a portfolio manager at Brandywine Global Investment Management.

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