China Bond Yields Drop To Decade Lows As Economy Sinks After New Loan Creation Tumbles

Following an unprecedented credit expansion by China, which in the first few months of 2016 injected well over a trillion dollars in total credit, the payback - as previewed here - is coming. As reported earlier, overnight China reported that a swath economic activity, from factory output to investment and retail sales, slowed last month, reflecting renewed weakness in China’s economy.

All three growth numbers announced by the National Bureau of Statistics Friday morning came in weaker than expectations and also slowed from June's level. The Industrial Production rose 6.0%, compared to the median forecast of 6.2%. Fixed asset investment slowed to another 16-year low of 8.1% during the first seven months, missing the median forecast of 8.8%. Retail sales growth also decelerated to 10.2% in July, lower than the median forecast of 10.5%.

Quoted by the WSJ, HSBC economist Ma Xiaopin said that "the Chinese economy is definitely on the downward trend. That hasn’t changed." Ma said demand from both home and abroad is still weak and investors are downbeat about China’s economic outlook.

In an unexpected decline, even the government-injected SOE fixed investment showed a substantial drop in its growth rate.

As the WSJ adds, July’s snapshot of China’s economy shows how broad the slowdown is becoming and how vexing that is becoming for the government. Growth of private investment, which accounts for around 60% of total fixed-asset investment, slipped to a record low of 2.1% in the first seven months, shrugging off recent official efforts to slash red tape and reduce market barriers to encourage more spending.  As companies hold off spending, government officials and economists have warned that China is falling into a liquidity trap—when investors hoard cash rather than invest despite government moves to put more money into the economy.

A key cause of the slowdown was the dramatic drop in the growth of China's comprehensive Total Social Financial funding, which rose just CNY478 billion, less than half the exoected CNY1 trillion growth, and the lowest in over two years.


As the chart below shows, while new loans posted a modest increase, other shadow debt categories such as bankers acceptances and FX loans continued to contract.


As a result, while Chinese stocks rebounded to close higher, China's 10-yr yield dropped to the lowest since 2006 as weaker-than-expected economic data weigh on growth outlook and stoke speculation of, what else, further stimulus.  Yield on bond due Aug. 2026 down 3 bps to 2.66%, lowest for the benchmark since Bloomberg started compiling ChinaBond data in 2006, dropping even below the financial crisis lows lows.


As MarketNews adds, the sharp decline in yields comes as investors brace for slower economic growth and expect monetary easing to be stepped up. "The Chinese economy will slow further in the third quarter and CPI growth will decelerate," said Huang Wentao, a Beijing based bond analyst with China Securities. "The drop in yields is far from over and 2.5% is just around the corner."

The People's Bank of China has been standing firm against growing calls for monetary easing. In its second-quarter monetary policy report issued last week, the central bank repeated comments made at the beginning of the year that frequent cuts in banks' deposit reserve requirement ratio will fuel depreciation pressure on the yuan.

"The PBOC's attitude is quite clear, but in China it is not the central bank that makes the final call on monetary policy," said a Beijing-based official with an asset management company under a major state-owned power producer. "It is a collective decision made by the State Council and we all know other government agencies want further easing."

 The National Development and Reform Commission, the powerful economic planning agency, called for cuts in both interest rates and deposit reserve ratios in a statement last week about the outlook for investment. The comments were later removed from the document, raising suspicions that there are disagreements among policymakers about monetary easing.

In spite of the central bank's stand, many analysts and investors say the government will have to cave in sooner or later as economic growth continues to slow and inflation moderates.

"We believe pressure from the economy and inflation will force the PBOC to change its attitude," said Huang of China Securities.

"There is a limit to the PBOC's resistance," Huang said, pointing out that recent rate cuts in the UK, Australia and New Zealand illustrate that policy easing is a global phenomenon.

As economists at ANZ Banking Group and Commerzbank have pointed out, China is facing a liquidity trap, a state where monetary policy easing through lower interest rates and injections of funds fails to stimulate spending and investment and manifests itself in companies hoarding cash rather than investing.

Huang said that even though this is the case in China, the monetary authority and the government will have to act just to show it's doing something in the face of slowing growth and disinflation.

The National Bureau of Statistics announced this week that the CPI rose 1.8% y/y in July, moderating from June's 1.9% despite massive flooding and the start of the summer holiday season which temporarily boosted fresh vegetable prices and travelling costs. China International Capital Corp, a leading domestic investment bank, forecasts CPI will ease further to around 1.6% y/y in August.

China's economic growth was 6.7% y/y in the second quarter, the same pace as in the first quarter, but many analysts expect the momentum to wane toward the end of the year as the impact of earlier fiscal and monetary stimulus fades. 

Liquidity conditions are also helping to send yields lower.

Insurance companies have entered into about CNY1.4 trillion of five-year certificates of deposit back in 2011-2012. These CDs will mature in 2016 and 2017 and the funds released will need to find a new home, Guotai Junan Securities said in a research note.

"Interest rates back in 2011 and 2012 were quite high so that money will need to find new assets with good returns to invest in," Guotai analysts said.

The hunt for yield has become so desperate that investors have been forced into corporate bonds sold by steel companies and coal miners, shrugging off concerns about the high-risk nature of the products after a series of defaults by Dongbei Special Steel Group.

"They offer higher returns than other bonds do in the market," said a trader with a bank based in southeastern China. "You just have to be selective and avoid the obvious minefields."

The spread between five-year medium-term notes and Chinese government bonds of the same maturity has narrowed by 11 basis points since August to 123.92 basis points on Monday, its lowest level on record.

With yields falling to multi-year lows, the market is becoming increasingly divided on the outlook for bond yields. Both Guotai Junan and Huang Wentao of China Securities expect the 10-year government bond yield to drop to around 2.5% but others warn that current yields level are too low and will have to rebound.

"The market has priced in too much of easing expectations and should those expectations fail to materialize, we will see a big correction in the bond market," warned a Shanghai-based bond trader with a city commercial bank.

The yuan edged up against the U.S. dollar this week, on the first anniversary of the central bank's shock change in the way it set the yuan's daily fixing against the greenback. The move led to a one-off 1.9% devaluation in the Chinese currency and triggered turmoil in global financial markets.

Since then, the yuan has dropped 5.07% against the dollar although most analysts expect the currency to stabilize or even appreciate in the runup to the Group of 20 summit in the Chinese city of Hangzhou in September and ahead of the yuan's inclusion in the basket of currencies the International Monetary Fund uses to value its Special Drawing Rights.

China remains stuck between a rock and a hard place: it needs to ease, but any material rate cut or RRR reduction will be promptly met with even more FX outflows, and even more forced selling of reserves to defend the currency. Ultimately it will have no choice but to decide which is more important: growth, albeit artificial and credit driven, or reserves and the level of the Yuan. In the meantime, expect Chinese yields to continues sliding lower as the global dash for "safety" has fully crossed into the Chinese border.