MNI China Money Week: Bond Bears Rule as CGB Yields Breach 4%

--Yields on 10-year Chinese Govt Bonds Exceed Key Level for 1st Time in 3 Years

--Banks Stay on Sidelines Amid Funding Shortage 

     BEIJING (MNI) - The gloom in China's interbank bond market deepened this

week as the yield on the benchmark 10-year Chinese government bond (CGB)

breached the key 4% level for the first time in three years, and traders see

little prospect of any meaningful reversal over the short term. 

     The bear market that's had CGBs firmly in its grip over the past year amid

the government's campaign to force financial institutions to deleverage has been

exacerbated over the past few months as banks have lacked the firepower to buy

bonds and non-bank financial institutions, especially funds, have chosen to

focus on higher-yielding debt such as corporate bonds, as Money Week highlighted

last week. 

     The yield on the most-actively traded 10-year CGB, which matures on Aug. 3,

2027, rose by 11 basis points in two days, jumping from a closing level of 3.90%

last Friday to 4.01% on Tuesday afternoon, the biggest two-day jump since the

end of October, before falling back to 3.9350% on Friday afternoon after the

central bank threw money into the interbank market. It added a net CNY810

billion via open-market operations from Monday to Friday, although taking

account of CNY189 billion of maturing Medium-term Lending Facility loans, the

net total amounted to CNY621 billion.

     "I think the market has gone into panic mode," a Beijing-based bond trader

with an asset management firm told MNI. "I just can't see a rational explanation

for this sudden jump in yields. October economic data came out on Tuesday and

the numbers were weaker so yields shouldn't be going up like this."

     There was a fleeting glimmer of good news for investors on Wednesday, when

an auction of seven-year government bonds produced a yield of 3.9644%, lower

than the 3.9896% yield in the secondary market. Some traders took this as a sign

that banks had begun to buy bonds. However, according to Deng Haiqing, the chief

economist at Jiuzhou Securities, banks "are under orders to make sure CGB and

policy-bank bond auctions are successful." 

     That is to say, weak demand in the primary market is bad news for the

secondary market, but positive signals coming from the primary market won't

necessarily translate into large-scale buying from banks in the secondary

market.

     Overall, analysts and traders are gloomy about the short-term outlook in

the absence of any obvious drivers to push bond prices higher and point to

several technical and regulatory factors that are likely to keep prices

depressed. 

     "There is still space for bond yields to rise further," Li Huiyong and Qiu

Difan, analysts at Shenwan Hongyuan Securities, wrote in a report this week.

Although yields on 10-year CGBs have already risen around 135 basis points since

October last year, that's not a record surge, they said. 

     Based on previous bond bear markets, there could be more misery to come,

they said. In the 2006-2007 slump, yields rose by 170 basis points, and in the

two-year market correction that ended in February 2011, yields rose by 146 basis

points and jumped by the same in the 2012-2013 bear market, they said. 

     "So if the market follows previous patterns, 10-year CGB yields could rise

as high as 4.05% to 4.35%," Li and Qiu said.

     Analysts at Hua Chuang Securities warned investors to "be well prepared for

a continued rise in government bond yields, which will remain above 4% for a

long time."

     CGB yields at this level should make them more attractive to long-term

investors, mainly banks that would normally wade in to calm and stabilize the

market. But recently they didn't show up.

     Yields on three-month CGBs, which carry very little interest-rate risk and

so are a good reflection of demand from banks, have jumped this quarter, rising

from 3.2192% on Oct. 9, when the market re-opened after a holiday that began on

Sept. 30, to 3.6317% on Thursday this week, the highest since October 2014. That

suggests banks have little firepower to buy bonds. 

     "The pressure on banks on the liabilities side of the balance sheet is

what's behind this weak demand even though at these levels bonds offer good

value in the long term," Sun Binbin and Tang Xiaotian, analysts at Tianfeng

Securities, said in a report on Wednesday, pointing out that growth in bank

deposits this year has fallen significantly, constraining banks, the biggest

players in the interbank market, from buying bonds. 

     Data from the People's Bank of China shows that outstanding bank deposits

have risen 9.1% y/y as of October, lower than the 11.5% increase in the same

period last year.

     The government's crackdown on leverage has made it harder and more

expensive for banks to raise funds in the interbank market through the issuance

of negotiable certificates of deposit (NCDs), and has crimped demand for NCDs

among other financial institutions. 

     "We can see from the third-quarter earnings reports of publicly listed

banks that their interbank assets are contracting," China International Capital

Corp. (CICC) said in a report this week. "Some of that is accounted for by a

decline in so-called idle funds in the banking system, and the impact from that

should be limited. But the rest of the funds ultimately go to the real economy,

so the contraction has led to a drop in corporate deposits."

     Another manifestation of the pressure on bank liabilities is the difference

in the growth rates of M2 money supply, which reflects the growth in deposits,

and new loans. 

     "Currently, the gap between M2 growth and loan growth is at one of the

lowest levels on record," the CICC analysts wrote. "History shows that when M2

growth is lower than loan growth, banks' ability to buy bonds will be limited

and bond yields will then rise. So there is a negative relationship between this

gap and yields." 

     Every month this year, M2 growth has been smaller than the increase in new

lending. The gap has widened from 1.3 percentage points in January this year to

4.2 percentage points in October, the widest since September 2009, when the gap

was 4.8 percentage points.

     Yields on NCDs have also risen sharply recently, another sign of pressure

on banks. They are having to offer higher yields to entice buyers as they boost

sales to refinance maturing certificates and raise new money as other avenues of

funding dry up under the deleveraging campaign. The yields on three-month NCDs

issued by joint-stock banks jumped from 4.7000% last Friday to 4.8890% this

Friday, the biggest weekly jump since February, while net issuance of NCDs this

week was more than CNY90 billion, the highest since early September.

     Given all the pressure on the banks from so many different directions,

traders say it's unlikely the bear market will end soon if banks can't get

enough money to buy bonds.

     "Banks' funding capabilities might improve if local government bond

issuance slows down or loan demand weakens," a Beijing-based bond trader at a

securities company told MNI. "But there are two important factors working

against the banks -- they have low excess reserves and short-term yields,

especially on money-market funds, are high, which is attracting deposits to flow

out of the banks. Neither of these factors are likely to change in the short

term and will continue to constrain the banks' ability to buy bonds."  

     Some analysts say there are signs that demand for loans could soften as

economic growth slows and the government follows the spirit of Xi Jinping's

report to the 19th Party Congress, which emphasized quality over speed. 

     "We clearly feel that the government is paying more attention to the

quality of economic growth now, rather than the quantity," Li Qilin and Zhong

Linnan, analysts at Lianxun Securities, said in a report this week. "This means

that irrational demand for funding will be restrained next year," which points

to lower demand for loans.

     But local government bond issuance will probably remain elevated and the

pressure will be greatest in the second quarter of next year. Li and Zhong

estimate that some CNY3.48 trillion of bonds will be issued under a program

started in 2015 to allow local governments to swap the more expensive debts of

their local government financing vehicles into cheaper municipal bonds before

August 2018. 

     On top of that, there could be as much as CNY1.2 trillion of special

construction bonds in the pipeline for 2018, as well as expected local

government bond issuance of CNY830 billion.

     That will take the total issuance of local government bonds to about CNY5.5

trillion, lower than 2016 but higher than 2017, they said. 

--MNI Beijing Bureau; +86 10 85325998; email: he.wei@marketnews.com

--MNI Beijing Bureau; +86 (10) 8532-5998; email: vince.morkri@marketnews.com

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