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China Money Policy outlook may flatten curve

SHANGHAI - China’s bond curve may finally be on the verge of flattening, a sign that monetary policy expectations are changing and that the debt market is looking ahead to tighter liquidity.

The spread between the one-year and 15-year government bond yields ballooned by 228 basis points from early October to a multi-year high of 273 bps hit on Wednesday last week.

Extremely loose money market liquidity, the result of a drastic easing of monetary policy, kept short-end yields down; meanwhile, expectations that an eventual economic recovery would revive inflation boosted long-term yields.

But since mid-March, the steepening has slowed dramatically, causing traders to speculate that the spread may soon start coming down to more normal levels.

“The bond curve previously steepened so much because of the combination of ample liquidity and concern that strong loan growth might lead to inflation once the economy picks up,” said Lin Chaohui, fixed income analyst at Guotai Junan Securities.

“But now the whole curve is likely to shift upwards and start flattening slightly this month, with short- and medium-term yields rising fastest.”

The one-/15-year spread, now at 272 bps, has essentially moved sideways since mid-March, and some technical indicators show a good chance that it is peaking; 14-day momentum has recorded repeated negative divergences in recent weeks. A negative divergence is a classic sign of the reversal of an uptrend.

Bond Supply

One reason for the market’s change in tone is a shift in expectations for supply. Last week the finance ministry announced it would hold 21 government bond auctions in the second quarter of this year, up from only three auctions in the first quarter, as it funds China’s massive fiscal stimulus plans.

The market had been expecting much of the new supply to be concentrated in the long half of the curve, so it was surprised by the ministry’s auction schedule: Sixty two percent of this quarter’s sales will be of bonds with tenors of three years or below, and only 10 percent will feature tenors above 10 years.

That means more emphasis will be on short-term bonds than there was in 2008, when 37 percent of government bond auctions during the whole year were for tenors of three years or below, and 20 percent were for tenors above 10 years.

Also, the government has refrained from expanding its fiscal spending plans beyond the 4 trillion yuan ($585 billion), two-year stimulus package that it announced last November.

It has pledged to add more stimulus if needed, but tentative signs of economic recovery—including strong fixed asset investment, rocketing loan growth and a rebound in car sales—may make additional fiscal spending unnecessary.

This has encouraged some analysts to cut their forecasts for government bond issuance this year. China International Capital Corp, for example, on Tuesday lowered its estimate of net new issuance to 560-610 billion yuan from 700 billion yuan.

“Since net bond issuance and the proportion of bond sales above 10 years are both lower than our original forecasts, supply pressure (in long-term government bonds) will ease,” CICC said.

POLICY

Meanwhile, traders are looking ahead to the day when the central bank begins to drain funds from the money market, in order to limit a return of inflationary pressure as the economy recovers late this year.

The massive loan growth in particular suggests the start of such policy tightening is drawing closer, though many traders think it is still at least a month away.

Any drive to absorb money market liquidity would almost certainly involve the central bank expanding its issues of three-month bills, and possibly resuming issues of one-year bills, which were suspended late last year.

That could quickly lift short-term bond yields off their multi-year lows and begin to normalise the yield curve.

The prospect already seems to be affecting auctions of three-year local government bonds. Sichuan province sold bonds at 1.65 percent on Tuesday, against 1.63 percent for Henan’s bonds last Friday and 1.60 percent for Anhui’s bonds late last month.

“Short-term yields are rising as local government bond yields edge up at auctions. People think short-term yields are too low compared to the long end to be attractive for their trading accounts,” said a trader at a securities firm in Shanghai.

How far could the bond curve flatten back in coming months? Technically, a logical target for the one-/15-year spread is its previous peak in recent years of 186 bps, which was hit in May 2007 and revisited in June that year.

Technical analysis also hold that the end of an uptrend is often followed by a 38.2 percent retracement of the rise. Such a retracement of the spread’s rise from early October would mean a target of 188 bps.