China’s Bond Traders Brace for More Pain as Slump Deepens

(Bloomberg) -- A slump in China's government bonds is set to deepen as traders' hopes for aggressive monetary easing quickly evaporate.

The yield on sovereign notes due in a decade touched 2.85% on Wednesday, the highest level since February, before pulling back. The high extended the surge since the start of May to about 30 basis points, making the bonds the world's second-worst performer after Bulgarian debt. The yield rose four basis points to 2.83% as of 4:03 p.m. Thursday in Shanghai.

Investors are concerned that Beijing will refrain from using broad easing to help the economy after the authorities announced a new policy to boost credit growth. That's the case despite the central bank saying Tuesday it is committed to looser monetary policy.

Also, a $380 billion funding gap this month will mean higher borrowing costs, making it less profitable for traders to buy bonds. Risk appetite is returning on optimism China is past the worst of the virus outbreak, with the benchmark stock gauge at the highest in nearly three months.

“Bond investors are so nervous now because they realize their strong faith in monetary easing was misplaced,” said Chen Qi, chief strategist at Shanghai SilverLeaf Investment Co. “Market sentiment is quite bearish, so it's not a good time to buy bonds. I expect the 10-year yield to rise to 3% in the near term.”

These charts illustrate the bearishness in China's fixed-income market:

It's becoming less profitable for investors to use short-term funding from the interbank market to buy government notes. The premium that China's one-year sovereign bonds have over the overnight repo rate has been narrowing since March, with the gap negative in seven of the past eight sessions.

The gap between China's 10-year and one-year sovereign bonds narrowed the most in May since late 2016, as the costs on shorter-dated notes surged faster than those on longer-dated ones. Some traders take this as a signal that a bear market is coming. That was the case in 2017, when China's government notes suffered their worst annual slump in four years.

Traders are pricing in tighter liquidity, which would be the result of policy makers refraining from monetary loosening. The cost on China's 12-month interest-rate swaps has continued to climb after surging the most in nearly seven years on Tuesday. The cost on the contracts will climb further, Citigroup Inc. analysts led by Sun Lu wrote in a note Wednesday.

It is also getting more expensive for investors to hedge against yuan depreciation, as reflected in a surge in the currency's one-year swap points in the onshore market. That means foreign investors -- who have snapped up Chinese bonds in most months since 2014 -- may get less interested in buying.

To be sure, some investors may view the bond selloff as overdone. The 14-day relative strength index on the 10-year yield is approaching 70, a level that in the past signaled a rout went too far. When that level was surpassed in October, the ensuing rally sent the yield to the lowest since 2002 just five months later.

©2020 Bloomberg L.P.

With assistance from Bloomberg