(Bloomberg) -- China’s central bank is readying a bold new experiment in global monetary policy — taking a leaf out of the hedge fund playbook and arranging to short sell bonds.
As President Xi Jinping and his top Party colleagues prepared for this week’s once-in-five-year Third Plenum to chart the broad economic path ahead, Governor Pan Gongsheng’s People’s Bank of China has been busy lining up “hundred of billions” of government bonds it could sell to prevent a bubble forming in the nation’s $4 trillion debt market.
Having long eschewed quantitative easing, the PBOC is now set to embrace the unorthodox policy of steering yields by dealing directly in the bond market, but from an unusual direction. Where the Federal Reserve and peers bought bonds to push yields down when their economies flat lined, the PBOC is readying to sell them to guide long-term yields higher as a rally extends to record levels.
It’s a policy experiment stemming from the complex and conflicting challenges confronting Pan. Mired in a property slump and beset by deflation, China’s economy clearly needs a low interest-rate environment; but not so low that it hurts bank profits, leads to a debt binge or weakens the yuan at a time of US dollar supremacy.
“With the ultimate goal of engineering a soft landing, this process is becoming more and more difficult to manage,” said Torsten Slok, chief economist at Apollo Global Management in New York. “There are so many moving parts that need to slow gradually.”
The PBOC didn’t immediately respond to a request for comment.
Compounding the problem, China’s slowdown has created a dearth of viable investment choices for its hundreds of millions of savers — outside of traditional haven bonds. Home prices are falling, stocks are in a funk and regulators are tightening the screws on risky alternatives.
“The equity market’s a disaster, credit is risky, real estate: Forget it. Foreign investments, well that’s curtailed and also got its own risks.” says 37-year market veteran Rajeev De Mello, a portfolio manager at GAMA Asset Management SA in Geneva. “It’s a real worry.”
The upshot: Seemingly ever declining yields and alarm bells at the central bank.
For one thing, falling yields are reinforcing speculation the PBOC will need to guide official interest rates lower, something it’s reluctant to do for fear of weakening the yuan further. China’s objective is the desire for a “powerful currency” that helps solidify the country as a major financial power.
And while low yields support growth by lowering borrowing costs for everything from corporate debt to residential mortgages, a protracted period of them just reinforces concerns about the Japanification of the Chinese economy.
Perhaps most worryingly for the PBOC, the surge in bond buying at low yields could lead to massive losses in China’s bank-heavy economy if inflation were to rekindle and yields were to spike higher. Some investors borrow to buy bonds, putting them at risk of a funding crunch if there’s a mismatch between short- and long-term yields.
Silicon Valley Bank’s collapse showed central banks around the world that they should monitor and prevent risks accumulating in the financial market, Pan said at the Lujiazui Forum last month.
Bloomberg reported Wednesday that China’s central bank started a fresh round of checks on bond investments at regional lenders to gauge the potential impact of bond sales and prepare for future steps, according to people familiar with the matter.
PBOC Gaming
Official warning shots since late April have largely fallen on deaf ears. Instead, investors keep chasing the momentum, skeptical about prospects for any near-term turnaround in the economy.
“The market is gaming with the PBOC,” and is probably right, said Chen Kang, vice president at Shanghai Tianzeng Private Fund Management Co Ltd. “Past market reversals were usually prompted by the economy improving, credit risks and tightening monetary policy. These things are unlikely to occur in the short term.”
What Bloomberg Strategists Say...
“Without significant structural reforms to foster consumption-led growth and manage the demographic transition, China is likely to follow further in Japan’s footsteps. Sustained low yields and sluggish economic performance will become the new norm.
Mary Nicola, strategist for Markets Live in Singapore
So the PBOC has decided on the direct approach. Without a suitable stock of Treasury bonds on its own balance sheet, it has arranged to borrow them from primary dealers for so-called open-market operations. That will allow it sell bonds at will to drag yields off the floor.
Markets are guessing when such a move will come. A Bloomberg survey suggested 2.25% was the red line for the PBOC for the 10-year yield, about where it was trading on Tuesday. The benchmark hit a record low 2.18% earlier this month.
A front-page report in a PBOC-backed newspaper suggested that a reasonable range would be 2.5%-3.5%. But to get back to that zone may take more than just the central bank’s efforts.
Data Monday showed second-quarter growth unexpectedly slowed to the worst pace in five quarters as faltering consumer spending undermined an export boom. Headwinds could escalate if former US President Donald Trump, who has threatened to raise tariffs on Chinese goods, wins reelection.
This week’s Plenum is a political rather than policy event, meaning investors shouldn’t expect any specific big-bang stimulus measures from it. Instead, a Politburo meeting toward the end of July looms as the next chance for the government to ditch its restraint and seek to juice growth.
The risk is that a continued lack of policy support makes the PBOC’s job to guide yields that much harder. And given the lack of long-duration government debt in the market, any yield rebound could end up being just an opportunity for bond bulls to get back in.
The balance of Treasury bonds stood at 30.4 trillion yuan ($4.2 trillion) in May, out of China’s 163.5 trillion yuan bond market, according to PBOC data, with the lion’s share held onshore. Speculative buying from retail investors, demand from fund managers riding a wave of inflows and purchases by companies seeking higher yields have helped drive this year’s rally.
While international investor positions have increased since late 2023, they still accounted for just 7% of holdings in May. Some are cautious about the PBOC’s aims.
News of the bond-selling plans “makes us more neutral,” said Neeraj Seth, chief investment officer for APAC fundamental fixed income at BlackRock in Singapore. “You don’t want to come in the way of the PBOC trying to readjust the curve.”
But for Carol Lye, a portfolio manager at Brandywine Global Investment Management, the bond rally still has some gas in the tank, not least with China’s growth still weak.
“There might be some bubble that’s forming,” she said. “At some point we would have to get out, but it’s just not time yet.”
--With assistance from Wenjin Lv, Masaki Kondo and Heng Xie.
(Updates with report on PBOC surveying regional lenders on bond holdings.)
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