What Is Behind China's Bond Rout?

Until a modest dip in Chinese bond yields in the past two days, 10y CGB and 10y policy bank bond yields soared by 40bps and 70bps, respectively, over the last 2 months. In fact, Chinese government notes are headed for the worst selloff since 2013, with the 10-year yield surging 86bps this year to 3.92%, and the yield of 10y CDB bonds rose above 5%. This bond rout and sharp spike in rates, caught the market by surprise, as the economic growth actually slowed in October and inflation is still below 2%.

What happened to drive up interest rates so sharply?

The most likely answer is also the simplest one: after years of aggressive debt expansion, leading up to October's Party Congress, China finally unleashed a sharp, aggressive deleveraging, which has finally been appreciated by the market in recent weeks, resulting in the biggest plunge in many local stocks in the past year, as well as a flurry of recent crashes in both Hong Kong and the mainland.

How to determine if this is correct? As Deutsche Bank observes, financial sector leverage can be measured by the gap between broad credit and M2 growth. The gap has narrowed significantly, reflecting the ongoing deleveraging process (Figure 1). More importantly, the inverted credit-M2 gap is a good leading indicator for bond yield, with a lag of about 3 months (Figure 2).

The next question is what's the link between financial sector leverage and bond yield? The answer is that when the financial sector leveraged up, smaller banks (city and rural commercial banks) aggressively expanded their balance sheet through wholesale funding, and increased holdings of longer term safe assets. The shadow banking sector also increased exposure to bonds, mainly through asset management funds. Small banks and fund houses together accounted for 82% of the incremental holdings in CGBs and policy bank bonds between 2014 and 2017 (Figure 3). In the deleveraging process, small banks and asset management funds become less expansionary (Figure 4).

Small banks further reduced bond purchases in late 2016 and early 2017, a period when bond prices fell and yields rose, in some cases violently, which in turn prompted the PBOC to aggressively inject liquifity ahead of the October Congress. However, with the Congress now in the past, last week China released new regulation on asset management products, which is leading to another round of reduced bond purchases by asset management funds, and which in turn pushed up bond yields. This is precisely what we discussed last week in "A New Era In Chinese Regulation Means Turmoil For $15 Trillion In China's "Shadows"

It is likely that interest rates may also reflect rising inflation expectations. While nonfood CPI inflation has been rising steadily (Figure 5) as it did in 2011, the benign headline CPI inflation has been largely masked by lower than expected food prices, such as pork (Figure 6). And, as in 2011, all it took was one sudden food price spike to unleash a sharp Chinese tightening, which sent shockwaves around the globe and resulted in the second and most acute wave of the Europen sovereign debt crisis, and eventually QE3 in the US and QE in Europe.

Ominously, lately food prices appears to have stabilized, and CPI inflation could rise further if food prices bottom out. In fact, according to Deutsche Bank, CPI inflation could reach 3% in early 2018 around the Chinese New Year. If inflation stays elevated in Q2, DB concludes that "investors and policy makers will likely become more concerned" - translation: China is about to launch another financial crisis.

But while the reason for the selloff may be known, what isn't is how much further will Beijing allow the rout to last, before it halts the deleveraging process - the same way it did in 2013/2014 - with the realization that like everywhere else, interest rates simply can not rise without bringing the entire financial system crashing down. Look for hints in the local press as to when Beijing - terrified of a middle-class insurrection - finally throws in the towel.

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There is another, more whimsical if less realistic explanation. As Bloomberg pointed out overnight, "short sellers may be aggravating China’s bond selloff" and although China's debt market has no official measure of short sales, "analysts say a surge in bond lending has been partially fueled by rising bearish bets." Bloomberg cites a record 1.82 trillion yuan ($274 billion) of notes has been lent out this year, 18 percent more than the total for all of last year, according to clearinghouse ChinaBond. Short sellers profit from falling bond values by selling borrowed notes and buying them back after prices fall.

There may be some validity to this as it "creates a vicious feedback loop - when institutions think bonds will fall, they borrow and sell, causing a plunge in the securities, which then drags futures down, and thus there’s more shorting," said Wang Wenhuan, an analyst at Huachuang Securities Co. in Shanghai. "As investors are still quite cautious, there will likely be more bond borrowing in the near term as yields climb."

As part of this recent jump in shorting, traders have borrowed 960 billion yuan of sovereign bonds and 710 billion yuan of policy bank notes this year.  The amount of overall bond lending started picking up late last year, when policy makers began intensifying their deleveraging campaign. Financial institutions borrowed 170 billion yuan of notes every month on average in the past year, compared with 92 billion yuan in 2015, when the bond market was stronger.

That said, not all bond borrowing is for shorting. It’s also used by traders in repo markets seeking financing when cash supply is tight. For example, a financial institution could lend out its corporate bonds in exchange for more liquid government notes, then pledge them in the repo market for funding, according to Becky Liu, head of China macro strategy at Standard Chartered Plc.

To be sure, while hardly the cause, it is likely that shorting did exacerabte the recent rout:

On Nov. 22, when the yield on China Development Bank’s 10-year debt surged to a high of 5.04 percent for the year, traders more than doubled their borrowing of policy bank bonds from the previous day. A similar jump in borrowing occurred amid a selloff of sovereign notes on Oct. 30.


"The increase in bond borrowing undoubtedly shows the market expects the yields to climb further," ANZ’s Qu said. "We still think the yields will rise, so against this background, the transaction volume of borrowing could continue to climb, accelerating the drop in bonds and even resulting in some overshooting."

However, like in the case of Europe (and US in 2008) the fact that shorting is still allowed in China is the best indicator that the worst is yet to come, and the authorities haven't freaked out just yet. Because once Beijing bans shorting - and shortly thereafter, selling - in China's gargantuan corporate bond market, that will be when the panic liquidations truly begin. Until then, enjoy the gradual levitation in yields until something does finally snap.