(Bloomberg) -- China’s bond traders are seeking shelter in a little played corner of the market to take advantage of bets on further interest-rate cuts that come with a lower threat of official pushback at a record rally.
The yield on seven-year government bonds dipped below 2% for the first time in history this week, out-pacing drops in rates in any other major tenor. That’s a sign traders are flocking to the so-called “belly” of the curve — one of the least traded portions of the market — as authorities pledge to contain the rise in longer-dated debt.
“It’s a good place to hide out,” said Carol Lye, a portfolio manager at Brandywine Global Investment Management. “The belly benefits from the rate cuts and yet it’s not in the bucket where the PBOC is trying to control the long-end of the curve.”
Chinese yields have smashed one record low after another, as investors flooded into haven assets in an economy pressured by a property crisis and weak demand. Policymakers slashed a string of interest rates and vowed to further support growth by lowering funding costs this week.
But the exuberance in bonds has one big caveat: potential intervention after warnings from the People’s Bank of China that yields are too low.
Traders have been fixating on whether the central bank will borrow and sell bonds to prevent the relentless advance from turning into a bubble that threatens financial stability. Any potential selloff would focus on long-end notes, analysts predicted.
That’s where the belly of the curve comes in, one of the least crowded parts of China’s yield curve.
Just around 1.6 trillion yuan ($214 billion) of five- to seven-year bonds exchanged hands in the cash market last month, according to official data on all debt types. That’s about a tenth of the trading in seven- to 10-year debt, the data showed.
“Investors might shift toward intermediate tenors like the seven-year bond to balance yield and risk,” if PBOC steps up intervention in the long-end, said Yingrui Wang, China economist at AXA Investment Managers. “The spread between seven- and 10-year could increase.”
The yield on seven-year bonds dropped to 1.96% on Thursday, extending this week’s decline to seven basis points. The 10-year yield was last at 2.12%, a fresh record low.
Any liquidity tightening in August may also prompt investors to favor the belly, as yields there will be more appealing than short-end notes, according to Andrea Yang, China macro strategist for global fixed income, currency & commodities at JPMorgan Asset Management. July saw sizable cash injections to China’s money market.
Of course buying seven-year bonds isn’t a no-brainer trade. Less-than-expected PBOC easing amid a surprise rebound in the economy or unexpected intervention in this portion of the curve are risks for the strategy.
But the sector is getting active, with total transactions last month 60% higher than July 2023.
“We find the belly of the curve a more attractive opportunity to us,” said Yang. “The current thinking is to maintain our position unless we see bazooka stimulus, which is unlikely.”
©2024 Bloomberg L.P.