(Bloomberg) -- A battle between China’s central bank and government-bond buyers is intensifying, as traders keep snapping up the debt despite growing evidence of official displeasure.
On one side is the People’s Bank of China, which skipped offering lenders short-term cash for the first time since 2020 on Wednesday — a sign it was seeking to limit leveraged buying of government debt. The move was made right after one of its branches asked smaller lenders to be more mindful of their bond exposure and some state banks sold sovereign notes in large sizes, putting upward pressure on yields.
On the other side are investors who only want to get their hands on the safest assets, as they flee from a sluggish stock market, sinking property prices and unappealing deposit rates. Demand is so strong that they snapped up government bonds at record low yields at the latest auction.
The saga underscores the dilemma Beijing is in: while it has to support the moribund economy by keeping funding costs low, it has to make sure money isn’t so cheap that a bond bubble is formed that jeopardizes financial stability. That’s why the PBOC seems to be sending mixed signals, slashing a string of interest rates in late July right after implying it may sell its debt holdings to cool the rally.
“The central bank is trying to tighten liquidity within a reasonable range to restrict leverage and rein in the government bond bull run,” said Zhaopeng Xing, a senior China strategist at ANZ Bank China. “The current liquidity is ample. There’s no need to further add cash into the market.”
Government bonds seem to be the biggest winners in China’s financial markets this year, as everything from stocks to corporate notes and to residential property is seen as too risky amid a sluggish economy. Benchmark yields plummeted below 2.1% for the first time in history this week.
That’s making the PBOC worried about financial instability in the event of a market reversal. To make it worse, the most aggressive buyers of sovereign notes — such as smaller banks — don’t have the balance sheets to protect themselves like their bigger rivals.
In a statement on Wednesday, the PBOC said “the overall amount of liquidity is reasonable and abundant” and it decided to not pump cash into the banking system considering demand from primary dealers. Analysts say that means Beijing is concerned with the bond rally.
Earlier this week, a branch of the PBOC in one of China’s most affluent provinces asked rural commercial lenders to better manage risks associated with bond holdings. State banks were seen selling 10- and 30-year notes in rarely large amounts in Monday afternoon to contain the bull run.
Trading of government debt exploded amid the standoff between PBOC and bulls. The average turnover for the most actively traded 10-year bond was 171.8 billion yuan ($23.9 billion) on Tuesday, more than three times than the sum seen on Friday, according to official data from the China Foreign Exchange Trade System. The daily volume for July was just 29 billion yuan.
Still, funding costs are low enough for traders to take advantage of. The cost on a short-term tool — popular among traders when they buy government bonds with borrowed cash — fell to the lowest level since January this week.
Trading volume on the contract climbed to a six-month high on Tuesday, a sign investors are adding leverage.
On Wednesday, China’s 10-year yield fell one basis point to 2.13%. The PBOC drained a net 252 billion yuan of short-term cash from the banking system.
“In line with the global movement and concerns about local leverage, today’s no-injection through OMO appears to be aimed at discouraging excessive bet on the China rates rally,” said Kiyong Seong, lead Asia macro strategist at Societe Generale HK Branch.
--With assistance from Iris Ouyang and Tania Chen.
(Updates throughout.)
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