Chinese leader Xi Jinping is vying with little success to turn stock bears into bulls. But over in the bond market, China faces the opposite problem with irrational exuberance pushing long-term yields too low.
That has authorities scrambling to tighten their grip on the globe’s third-biggest government debt market. On Monday, prices tumbled as the People’s Bank of China (PBOC) intervened assertively in the market. It was the worst day in 17 months for China’s 10-year treasury futures, sending yields up 4 basis points.
The recent plunge in bond rates is putting downward pressure on the Chinese yuan at a moment when Xi favors a stable-to-firmer exchange rate. The problem for Xi and the PBOC is that bond bulls argue the rally is supported by underlying fundamentals – including slowing growth and deflationary pressures – and has room to grow.
Beijing regulators have consistently aimed to boost the proportion of direct financing. When bonds and stocks are added together, it amounted to just 31% of total social financing last year, with the rest dominated by bank loans.
In the US, by comparison, the figure is more than 70%. Xi’s Communist Party plans to sell more long-dated sovereign bonds to finance plans to hasten growth in China’s US$17 trillion economy.
Yet in recent weeks, PBOC Governor Pan Gongsheng warned of bubble troubles as walls of capital flowed from shaky stocks and plunging property into bonds.
In July, outflows from Chinese equities “are mainly explained by the lingering challenges that investors see in the Chinese economy,” said Jonathan Fortun, an analyst at the Institute of International Economics.
It hardly helps that Asia’s biggest economy is seeing powerful outflows of foreign investment at home. China’s direct investment liabilities, a balance of payments barometer of incoming foreign investment, fell by $14.8 billion in the second quarter year on year, only the second time the figure has turned negative, according to Bloomberg.
The figure is down $5 billion in the first half of 2024, which if sustained throughout 2024 would mark the first annual net outflows since 1990. Those dwindling capital flows are happening while China’s own external investment is dwindling amid trade war tensions with the US and Europe.
All this has led to Pan’s PBOC stepping up efforts to tame the bond bulls. The challenge, though, is that the speculators testing Beijing are increasingly looking like so-called “bond vigilantes”, or activist traders who sometimes take matters into their own hands.
Pan’s team is about to learn firsthand what James Carville warned the globe about 30 years ago. In 1994, Carville was a strategist for US President Bill Clinton and is best known for his “it’s the economy, stupid” mantra. That year, Carville made another famous observation: that he’d like to be reincarnated as the bond market because “You can intimidate everybody,” he quipped.
The context was balanced-budget negotiations in Washington. Back then, bond traders were hypersensitive to the slightest pivot in Washington’s fiscal trajectory. Carville’s reference to the power of bond vigilantes is now China’s problem as traders reprice mainland assets.
Bill Bishop, who writes the Sinocism newsletter, observes that a “hopeful spin is starting to circulate about what the PBOC is doing is that perhaps the pressure on the buyers of government bonds is to get institutions to reduce their exposure before a more direct fiscal stimulus package that would spike yields. But the rush into these bonds is not a sign of confidence in the economy, or in the prospects for other asset classes.”
This week, regulators counseled commercial banks in China’s Jiangxi province against settling their government bond purchases. Prodding institutions to renege on trades is a bold move to reduce risk.
Trouble is, this could damage the integrity of a market that Xi has been slow to develop. If counterparties in bond trades worry additional transactions might go awry, trust in Chinese bonds could wane even further.
Too often in recent years, Xi’s regulators intervened in stock and foreign exchange trading, turning off global money managers. As such, it’s hardly surprising that foreign accounts are pulling record amounts of capital out of China’s economy.
“The PBOC had been repeatedly warning the market about rate risks since April but rates have continued to decline,” Becky Liu, head of China macro strategy at Standard Chartered, told Bloomberg. “This time, they want to send a strong enough message to the market, to better acknowledge their ‘comfort’ level of long-dated bonds, to reduce future speculative positions.”
In June, Pan even cited the Silicon Valley Bank collapse in the US in early 2023. The worry is that bond yields moving in unpredictable ways could unnerve Chinese regional banks.
“SVB in the United States has taught us that the central bank needs to observe and evaluate the situation of the financial market from a macro-prudential perspective,” Pan said. “At present, we must pay close attention to the maturity mismatch and interest rate risks associated with the large holdings of medium and long-term bonds by some non-bank entities.”
Entities in potential harm’s way include insurance companies, investment funds and other financial firms. That’s particularly the case as China flashes some Japan-like warning signs.
“Credit demand is weak due to the property woes. As a result, banks have to buy more bonds as money is trapped in the interbank market,” says Larry Hu, chief China economist for Macquarie Group.
Just as in the case of Japan in the 1990s, says Ken Cheung, currency strategist at Mizuho Securities, low government bond yields can do more harm than good to an economy.
Earlier this week, at least four Chinese brokerages implemented new curbs on trading in domestic government bonds. One went so far as to suspend dealing in certain maturities. This likely makes the threat of additional intervention “the main factor driving yields higher.”
For now, the financial equivalent of “the sword of Damocles is falling,” says Tan Yiming, analyst at Minsheng Securities. Tan notes that “while the scale of any selloff in China bonds may not be substantial in the medium and long term due to the fragile growth momentum in China, chasing duration returns in China does not seem appropriate in our view.”
But risks abound going forward. With this so-called “asset famine” environment where high-yielding assets are in short supply persisting, “the bond bull market remains alive,” Tan says.
That worry for Xi and Pan is that a bigger drop in Chinese yields would send the yuan lower. That might make it harder for giant property developers to make payments on offshore bonds, increasing default risks. It also might enrage US politicians ahead of the November 5 presidential election, where China has served as a punching bag for both parties on the campaign trail.
Of course, China isn’t alone in fretting about bond vigilantes. In Tokyo, the Bank of Japan is squabbling with traders trying to bid up yields faster than policymakers desire, causing the yen to skyrocket more than Tokyo wants.
In the US, meanwhile, the national debt topping $35 trillion at a moment of extreme political dysfunction could trigger speculators to pounce.
“The worry is that if public debt keeps blowing out in balmy times, the bond vigilantes will make a comeback and not fund deficit spending in a downturn,” said Tan Kai Xian, analyst at Gavekal Research. “This risk has been heightened by geopolitical tensions and moves to ‘weaponize the dollar,’ which is prompting non-US allies to consider diversifying away from Treasuries.”
Yet China’s challenges would be less daunting if its capital markets were ready for the global prime time. To build trust among global investors, Team Xi must accelerate moves to improve liquidity.
It must add new hedging tools, reform a giant and opaque state sector, devise a world-class credit-rating system and increase transparency to reduce risk and allow for better allocation of capital. These steps and others are key to increasing the appeal of the yuan as a top currency in trade and finance.
One recent step saw regulators prodding some of China’s biggest state banks to collect more details about buyers of sovereign notes. The idea is to tighten the leash on speculators. At the PBOC’s branch in Shanghai, officers are meeting with financial institutions to discuss bond market risks.
“The PBOC’s concerns on financial risks are valid,” says Citigroup economist Xiangrong Yu. “Whether its moves are sufficient to lift the long-end yield appears uncertain.”
At the moment, fundamentals may indeed support lower Chinese yields — whether the PBOC likes it or not. As analysts at Pictet Asset Management put it: “The lack of low-volatility investment opportunities should make Chinese government bond investments attractive for many investors, especially at a time when the country’s stock market remains under pressure and the economy recovers only slowly.”
It means authorities may have a harder time taming the market than many believe. Though heady demand for China’s government bonds dovetails with Beijing’s long-term agenda, it’s colliding with PBOC efforts to support the yuan.
All in all, the recent flattening of the yield curve has limited Pan’s policy flexibility, fueling renewed speculation that more monetary easing is coming. This explains why the PBOC’s tug-of-war with bond vigilantes is only just beginning – and why the battle won’t be an easy one for China to win.
Follow William Pesek on X at @WilliamPesek