MNI China Money Week: Mood Dims as 10-Yr CGB Yields Hit 3.8%

--Market Rattled By Speculation of Tighter Controls on Banks' Interbank

Liabilities   

--Yields Rise After Jump in U.S. Treasuries on Speculation Hawk John Taylor To

Lead Fed 

     BEIJING (MNI) - There was no respite for traders in China's interbank bond

market this week, as more bad news piled up after last week's mini panic

triggered by comments from People's Bank of China Governor Zhou Xiaochuan.

     Government bond yields jumped again this week as speculation swept through

the market that banks were about to be hit with an order to cut their interbank

liabilities to 25% of total liabilities from the current ratio of 33%. A central

bank denial issued through a report to the official Xinhua News Agency on

Wednesday evening failed to reassure the market and yields remained elevated on

Thursday.

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

Aug. 3, 2027, closed 6.5 basis points higher on Wednesday at 3.7850%, the

highest since it was issued on Aug. 2, 2017.

     On Thursday, the yield on the most-actively traded CGB jumped to as high as

3.8% before closing at 3.775%, lifted by the news that the PBOC was going to

conduct two-month reverse repos on Friday.

     Government bond futures sank on Wednesday, with the price of the 10-year

contract due on Dec. 8 dropping by 0.57% to 93.575 yuan, the biggest fall since

March, although it recovered slightly to 93.77 yuan on Thursday.

     Pressure from rising yields on U.S. Treasuries compounded the gloom. The

yield on the 10-year Treasury closed above 2.4% for the first time since May on

Tuesday after President Donald Trump conducted an informal poll of Senate

Republicans on whom they prefer to see as the the head of the Federal Reserve

when Janet Yellen's term as chair ends in February. Media reports said the

result pointed to John Taylor, a Stanford University professor who is viewed by

the markets as a hawk. According to the Taylor Rule, which was developed by the

academic, the Fed funds rate should be closer to 3% than the current 1.15%

level.

     Many Chinese analysts and traders said the PBOC speculation and the Fed

poll were not enough to fully explain the jump in CGB yields.

     Some doubted that the PBOC would cut the interbank liability ratio by so

much, given the likely impact on the market. Xu Hanfei, an analyst at China

Merchant Securities, said that 88% of joint-stock banks that have published

their half-year balance sheets have interbank liabilities higher than 25% of

total liabilities. Consequently, such a policy would deal a heavy blow to banks,

something regulators do not want to see even though they are pushing ahead with

their financial deleveraging campaign. 

     According to traders, speculation by analysts and some banks that the PBOC

would not, in fact, slash the interbank liability ratio resulted in a 0.5 basis

point decrease of yields on  Wednesday, before the yields went up again later in

the day.

     Others questioned the relationship between U.S. Treasuries and CGBs.

     "Ten-year Treasury yields fell from around 2.4% in January to around 2.0%

in September, while 10-year Chinese government bond yields rose from 3.1% to

around 3.6% during the same period, so the bonds have not been moving in the

same direction this year," Qi Sheng, a bond analyst at Zhongtai Securities, said

on Thursday. "So rising U.S. Treasury yields won't necessarily push up yields on

Chinese government bonds, especially considering the yield gap is around 130 to

140 basis points now, which is quite high historically."

     The most important factor governing the direction of the bond market right

now is the short-term nature of bond investment, which is amplifying weak market

sentiment, according to some traders and analysts.

     Funds began to increase their holdings of government bonds in June, and

continued to do so through September, betting that economic growth in the fourth

quarter would weaken and liquidity conditions would relax, Qi said.

     In the event, economic growth has been stronger than expected and financial

institutions who piled into the market for short-term gains had to cash out when

their bets soured to avoid further losses.

     Another indicator that short-term trading is driving the market is the

inverted yield curve that has emerged again, with yields on five-year CGBs

staying above those of 10-year CGBs starting from Oct. 12 through the past

Monday.

     "It is very unusual for yields on 10-year CGBs to be lower than those on

five-year CGBs," analysts at China International Capital Corp. wrote in a report

over the weekend. "The main holders of five-year CGBs are banks, who keep them

until maturity, while holders of 10-year CGBs are more diverse and include a lot

of financial institutions who are trading for short-term gain."

     The current situation is a reflection that demand for bonds is quite weak

among banks, but financial institutions are more optimistic, they wrote.

     "But the main players in the bond market are still banks. If financial

institutions looking for trading gains buy actively but banks don't respond by

buying more, bond yields cannot move into a downward trend," the analysts said.

"Historically, bond bull markets are driven by strong demand from both the

banks, who hold for the long term, and from other financial institutions who

want trading gains."

     Some traders take saw a solid signal for the bond market when the PBOC

conducted two-month reverse repos for the first time on Friday.

     "After the PBOC refuted the rumor about cutting interbank liabilities

quickly yesterday, it came up with a new idea to relax liquidity conditions

today. Isn't it obvious that the PBOC does not want to see the bond yields to go

up further?" a Beijing-based bond trader for a commercial bank said on Thursday.

"For me, the spring for the bond market has come."

     However, the weak sentiment continued to dominate Friday morning, as the

most-traded 10-year CGB yields went up to 3.80% again.

     Some analysts expect yields on 10-year CGBs to continue to rise in the

short term. China CITIC Securities has revised its forecast for 10-year CGB

yields' upper limit to 3.8% from 3.6%, while China Merchants Securities sees

yields going as high as 4.1%.

     A survey conducted Thursday by Zhaiquan Xiaoguan ("Bonds Cafe"), a blog on

the WeChat social media platform whose followers are mostly bond investors,

showed divergent views on where the market is heading. Around 45% of bond

investors who took part in the survey said 10-year CGB bonds yields will break

through 3.9% over the next week, while 33% said they would rise no higher than

3.8% and the remainder said they thought 3.85% would likely be the upper limit. 

     The survey also found that the primary concern of investors is regulation,

which drew 28% of votes, followed by weak sentiment.

     Some analysts think that now is a good time to buy bonds, as economic

conditions don't support a further rise in yields.

     "The turning point of economic growth has already passed, suggesting the

peak for bond yields is also near," Guosen Securities analysts said in a report

on Thursday. "Regulators are also in agreement that the financial deleveraging

campaign has had some effect, so although we believe we are unlikely to see any

relaxation of financial regulation, we don't think there will be any further

tightening."

     Others are warning investors not to rush in on hopes they'll be "buying at

the bottom."

     "It is certain that financial regulation will continue to tighten and

liquidity conditions are likely to remain slightly tight," Hua Chuang Securities

analysts said in a report on Wednesday. "At the same time, weak economic data,

if it appears, does not necessarily point to a weaker economy [as happened in

July]. Global yields are rising and that is also putting more pressure on

domestic bond yields."

     They cautioned that trying to gauge the bottom of the market was like

trying to catch a falling knife. "We haven't seen the last of the bad news for

the bond market, so this latest wave of falling prices hasn't ended yet," they

wrote.

     Benchmark seven-day deposit reverse repos averaged 2.867% as of Thursday

this week, slightly higher than 2.862% last week.

     The PBOC injected a total of CNY390 billion into the banking system via

open-market operations this week, the largest single weekly injection since

July.

     The yuan last traded at 6.6527 versus the dollar Friday morning, weakening

from 6.6200 at last Friday's closing. It was the second straight week that the

yuan has weakened against the dollar.

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

--MNI Beijing Bureau; +44 203-586-2244; email: nerys.avery@marketnews.com

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

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