MNI CHINA MONEY WEEK: Metals Rally, Inflation Worry Hit Bonds

     BEIJING (MNI) - A rally in metals and coking coal futures sent long-term

bond yields in China higher this week, triggering renewed concerns that

inflation will accelerate.

     The yield on the most actively traded 10-year Chinese government bond (CGB)

maturing on May 4, 2027, rose by around four basis points from 3.6226% at last

Friday's close to 3.6675% this Wednesday. This was within a whisker of the high

of 3.66765% reached shortly after the bond was issued in May, although by Friday

it had given back most of its gains and was trading at 3.6300%.

     Long-term policy bank bonds showed the same trend. The yield on the most

actively traded 10-year China Development Bank bond maturing on April 10, 2027,

rose around eight basis points this week to 4.3100% on Thursday, before falling

back to 4.2700% on Friday.

     "Ferrous metals started going up at the beginning of June, but didn't

really catch the market's attention at first," a Beijing-based bond trader at a

commercial bank said. "Some people in the market woke up to it in July and

that's when the rally really got going and looked like it had further to run.

     "But the soaring prices caught everyone's attention on Monday morning this

week, when rebar and hot rolled steel futures hit their daily upper limit of 6%

and coking coal jumped more than 4.5%," the trader continued. "The worry of

inflation pushed up long-term bonds yields."

     Steel rebar futures contracts and aluminium traded in Shanghai climbed to

their highest in five years, and coking coal traded on the Dalian commodity

exchange is hovering near the highest level this year.

     Rebar futures contracts for October delivery have jumped by around 37.2%

since July 5, from 2,939 yuan per ton to 4,032 yuan per ton on Aug 10. Coking

coal futures for Jan 2018 delivery soared by 65% from 1,295 on July 2 to 2,138

on Thursday.

     The commodities rally coincided with a loosening in liquidity conditions

that started in June as the People's Bank of China pumped cash into the

interbank market to ward off a potential shortage expected at the end of the

month. The central bank's largess continued into July, and much of the money

found its way into speculation on the country's commodity exchanges.

     President Xi Jinping's calls for progress on supply-side reforms, which

involves eliminating outdated production capacity, has led local governments to

announce targets for closing -- or actual closures of -- coal mines as well as

steel and aluminium plants. That's fed expectations that prices will rise as the

capacity cuts hurt output and may lead to shortages. Stronger-than-expected

economic growth and infrastructure spending in the first half has also spurred

hopes that domestic demand will remain strong through the end of the year.

     The PBOC has also reverted to its stance of keeping liquidity in a "tight

but stable" condition, which is contributing to the unfriendly environment for

long-term bonds.

     The PBOC did not add any net funding to the interbank market via open

market operations for eight straight trading days through Wednesday this week.

On Thursday, it finally relented with a meagre CNY20 billion injection, although

traders speculated this was only because the seven-day deposit repo rate had

risen to 2.9242% on Wednesday, above the 2.6%-2.9% range the PBOC had specified

to in its first-quarter monetary policy report.

     The PBOC OMO on Friday merely offset maturing repos, with no net add or

drain. 

     "Recently the PBOC has taken to just rolling over maturing reverse repos,"

said an interbank trader based in southern China. "Although I expect liquidity

will remain in this 'tight but stable' situation, I'm still staying cautious in

case things get tighter."

     Better-than-expected economic data have also contributed to the bond

sell-off, as investors have become more concerned that growth will remain robust

and further hurt the bond market.

     "The economic data have shown that growth momentum has not slowed as much

as the market was expecting, instead it's shown resilience," Zheng Kuifang and

Xu Yao, analysts at China Construction Bank, said in a research note on

Wednesday. "There's no consensus in the market about the outlook for economic

fundamentals."

     Although industrial output and investment growth have picked up, the

consumer price index and producer price index have been relatively stable, with

factory-gate prices rising by 5.5% year-on-year in July, the same pace as the

previous two months, defying expectations that PPI gains would keep falling from

February's peak of 7.8%.

     The shift in expectations has hurt sentiment among bond investors.

     "In recent months the market had been generally optimistic about the bond

market because investors expected economic growth would weaken and the

regulatory environment would loosen up in the second half of the year," Qu Qing

and Bai Yuhan, analysts at Hua Chuang Securities said in a report on Thursday.

"Bond yields were relatively high, so the general view was that the bond market

was likely to do well in the second half.

     "However, these expectations have not materialized, and that's had quite a

big negative impact on market sentiment," they wrote, adding that the lack of

impetus in the bond market is putting the performance of many funds and

financial products under pressure.

     Some traders and analysts say that the economic fundamentals suggest bond

yields won't go much higher for long, especially as the surge in metals and

coking coal prices is being driven more by speculation rather than real demand

and supply conditions.

     "I don't think the rising price of ferrous metals necessarily means

inflation will pick up and the economy will stay strong," a Beijing-based

interbank trader at a commercial bank told MNI. "What's happening to ferrous

metals is only going to have a short-term impact on sentiment."

     Guosen Securities said in its Tuesday research note that while the economy

performed better than most were expecting in the second quarter, "if the

fundamentals don't improve, then ultimately the market will be disappointed" and

that will push bond yields lower.

     The bond market may also get some support from the unexpectedly strong

appreciation of the yuan over the last few weeks, some analysts say. The Chinese

currency strengthened against dollar this week for the fifth straight week and

broke through the 6.7 per dollar level on Wednesday and Thursday. On Friday, it

was last trading at 6.6698.

     "Yuan depreciation expectations have lasted for two years, but now the mood

is shifting and the market is looking at appreciation," Chen Jianheng and Tang

Wei, analysts at China International Capital Corp. said in a report on

Wednesday. "That will have a positive impact on the PBOC's outstanding

foreign-exchange purchase position and help to improve liquidity conditions,"

they added, which will benefit bond yields.

     The outlook for the bond market in the short term will still likely depend

on how ferrous metals perform.

     "The commodity market rally is being driven by ferrous metals, and as the

optimism is based on supply-side reforms, the momentum for further gains is

still there," Qin Han and Liu Yi, analysts at Guotai Junan Securities wrote in

their Tuesday report. "So as long as ferrous metals continue to power ahead, the

bond market will continue to suffer.

     The yield on 10-year CGBs touched 3.7% in May and the consensus in the

market was that that would be the peak for 2017, Qin and Liu said, pointing out

that yields  traded in a narrow range of 3.55% to 3.6% in July.

     "That showed investors bought CGBs when yields rose above 3.6%, pushing

them back down," they wrote. "However, that consensus could be broken if yields

rise because of some negative news which may force investors to reconsider that

3.7% ceiling. If that level is breached, we could see some panic."

     The PBOC drained a net of CNY30 billion via its open market operations this

week, the second consecutive week of net drain.

     The benchmark seven-day repo rate was last at 2.8289% on Friday, up from

2.7879% last Friday.

     The yuan was last traded 6.6698 against dollar on Friday, strengthened from

6.7181 last Friday. This is the biggest weekly gain since the week of June 26 to

June 30. 

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

--MNI BEIJING Bureau; +1 202-371-2121; email: john.carter@mni-news.com

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