The Market's Next Headache: China's (Not So) Stealth Tightening

While much of the attention in the past month has focused on the rising interest rates among the Developed markets, a just as troubling development is taking place in China where as BofA's David Cui observes, interest rates are set for sustained upward pressure over the next few quarters, for the fifth time since 2006.

Since Oct 21, yield of 10Y Chinese Government Bond (CGB) has risen by 20bps, from 2.65% to 2.85%, partly in response to the strong global rates and USD move since the US election. Cui expects the yield to rise further to 3.40% by the end of 2017. Furthermore, with credit spreads near all-time lows, the bank warns that there is a risk that it may widen sharply at some point.

As Cui further writes, the local equity market reacted progressively less favorably to rising rates the last four times as investors turned progressively less optimistic about growth outlook. The bank believes that "the rising rates this time may put pressure on equities in general as it would occur in an environment of lackluster growth." Sector wise, property, materials and utilities may suffer the most; while insurers, IT and consumer may benefit. That said, please bear in mind that interest rate is only one of the major drivers of the equity market.

To be sure, how the equity market reacts to rising rate depends on reasons behind the upward pressure. If it is caused by strong economic growth outlook, it is typically good for stocks, at least in the early stage of the tightening cycle (when the market tends to enjoy upside revenue surprise). This was clearly the case with Episodes 1 and 2 (Chart 6).

However, when rising rate was caused by no-growth factors, such as inflation and the government's desire to control debt growth (which seemed to be the case with Episodes 3 and 4), the market reacted much more cautiously. This time, the pressure appears to be mainly driven by a less accommodating monetary policy as a result of housing bubble risk, debt control need and exchange rate pressure, despite a fairly lackluster economic growth outlook. In this case, Cui concludes, "the rising rate should not be a net positive to the equity market, in our view."

What makes China's situation especially curious, because the implications from higher rates for a country which has a record corporate debt bubble are pernicious, is that while market forces have already tightened financial conditions as a result of recent developments in the US, this move has not only not been offset by the PBOC, but has been blessed by the Chinese central bank: as Bloomberg writes overnight, "without a policy announcement, China’s central bank has effectively tightened monetary conditions in recent weeks, an analysis of its transactions shows."

The PBOC has quietly tightened by gradually shifting the maturity distribution of repo operations away from 7-Day toward 14- and 28-day operations, which both have modestly higher rates. Specifically, in recent weeks, the PBOC has cut back on seven-day open-market operations and is instead injecting more funds through 14-day and 28-day contracts. That’s had the effect of raising short-term borrowing costs and pressing up bond yields.

While the central bank injects money with seven-day reverse repurchase operations at 2.25%, it has started offering 14-day and 28-day contracts at rates as much as 30 basis points higher. The end result is secondary market one-week funding costs of around 2.5%.  According to Bloomberg, this is another sign of selective tightening by the PBOC that’s reinforced the views of many economists that China has turned the corner away from monetary stimulus.

 

A breakdown of recent repo operations is shown below:

As a result, interbank rates have “basically gone up 20 to 30 basis points,” said Ming Ming, the head of fixed-income research at Citic Securities Co. and an ex-PBOC official. “China’s central bank has essentially raised rates by 25 basis points through money market operations,” said Deng Haiqing, chief economist at JZ Securities Co. in Beijing. “The bond market adjustment is only beginning. We expect the yield curve steepening to be the main feature of the market in 2017, driven by mild PBOC tightening.”

Why the quiet shift? One explanation is that with economic growth stable, policy makers are trying to rein in leverage in the world’s No. 2 economy. The impact is being felt in the debt market, where the government yield curve has reached the steepest since April and the yield premium on three-year AAA corporate bonds is set for the biggest jump in seven months.

However in an economy driven entirely by cheap, abundant credit, the downside will promptly emerge: it has already started to hit bond markets, where returns are being hurt by this effort to squeeze financial-market leverage. Just as troubling is BofA's suggestion that this time around, rising rates may be caused by "no-growth factors", such as inflation and the government's desire to control debt growth, and that the pressure appears to be mainly driven by a less accommodating monetary policy as a result of housing bubble risk, debt control need and exchange rate pressure, despite a fairly lackluster economic growth outlook. As noted above, BofA's conclusion is that "the rising rate should not be a net positive to the equity market." Which means "negative", and suggests that one of China's many concurrent debt-fuelled bubbles may be about to pop.

While it remains unclear what the immediate consequences of the PBOC's change in strategy are, one thing appears clear: “We don’t expect monetary policy to be eased further,” said Jing Lei, Beijing-based chief investment officer of fixed income at Harvest Fund Management Co., which manages 315 billion yuan ($46 billion). “All the regulators are trying to control the leverage in financial markets.”

And with a recent spike in defaults, the recent push to tighten conditions will only accelerate this trend: at least 23 onshore bonds have seen defaults this year, still a small figure but up from just seven in 2015. 

Another clear outcome: investors have been turning more cautious with leverage in the interbank market falling. Outstanding repurchase agreements reached 8.9 trillion yuan in October, down from a record 9.7 trillion yuan in December, the latest National Interbank Funding Center data show.

Of course, the fundamental driver behind China’s rising sovereign yields, along with those of counterparts around the world, has been the market's reaction to U.S. President-elect Donald Trump’s stimulus policies, steepening the yield curve as seen below:

“You can see a little more steepening of the curve,” said Neeraj Seth, head of Asian credit at BlackRock Inc. in Singapore, which is waiting for buying opportunities in long-end notes.

In any case, should the dollar continue to rise, sending US rates and inflation expectations even higher, Chinese rates wil have no choice but to follow (or else risk even greater rate-differential driven capital outflows - until the financial sector stress become unbearable for Beijing, and another "Shanghai Summit" takes place, one in which however instead of pro-reflation policies, the world's monetary policy makers decide it is time to enact a new round of global monetary easing. How that will fit in with Trump's proposed $1 trillion in fiscal stimulus remains to be seen.