China yield curve inverted as regulators target leverage risk

The yield on Chinese five-year government bonds hit its highest since 2014 on Friday, as tight liquidity and a regulatory crackdown on leveraged investment caused a rarely seen inversion of the yield curve.

Bond yields, which move inversely to price, have been on the rise since last October as the People’s Bank of China moves to discourage the use of borrowed money for bond investment.

The bond shakeout has accelerated since March, as regulators issued a series of directives to curb financial risk.

Lending ties among financial institutions have grown increasingly complex in China, with lenders issuing certificates of deposit to some banks to buy high-yielding wealth management products from others. Issuers of such products then entrust the funds to third-party asset managers such as trusts, insurers and fund companies.

“New regulation is focusing on curbing new off-balance-sheet investments, while letting existing portfolios roll off slowly,” said Hao Hong, head of research at Bocom International in Hong Kong. “It’s going to be a long and painful process, and the market seems to have underestimated the authority’s resolve this time.”

Despite rising bond yields, analysts expect credit to the real economy to keep growing strongly, as authorities are committed to meeting the government’s target for gross domestic product. Rather than cutting off corporate and household debt, regulators are mainly focused on curtailing leverage within the financial system.

Market participants say uncertainty about the impact of regulation has sparked excessive caution among some banks. In April, the China Banking Regulatory Commission ordered lenders to conduct reviews of “irregularities” in their interbank business but did not issue specific rules on what was allowed, according to an executive at a foreign bank in Shanghai.

“Trends in the real economy don’t support a large increase in yields,” Ming Ming, chief fixed-income analyst at Citic Securities in Beijing, wrote on Friday. “There are some irrational factors contributing to recent interest-rate movements.”

In addition to tighter regulation, the central bank has also grown stingier about supplying the banking system with fresh funds. The People’s Bank of China drained a net Rmb120bn ($17.4bn) from money markets through open market operations this week, bringing the total net drain through this mechanism in 2017 to Rmb925bn.

On Thursday, the benchmark yield on five-year Chinese government bonds rose above the 10-year yield, the first such inversion since data from the National Interbank Funding Center began in 2010. In general, longer-dated bonds carry higher yields, in part because a longer investment timeline multiplies the probability of default or other risk events.

But on Friday, the PBoC softened its stance somewhat, injecting Rmb459bn into the market through its Medium-term Lending Facility (MLF). This injection will amount to a net injection of cash even after the Rmb230bn in MLF loans that matured last week and an additional Rmb180bn due to mature next week.

The five-year yield on government bonds hit 3.74 per cent on Friday afternoon, the highest level since December 2014 and above the 3.66 per cent level for 10-year bonds.

Analysts say that yield-curve inversion mainly reflects differing supply-demand dynamics demand for five- and 10-year tenors. The rising cost of short-term funding and regulators’ emphasis on deleveraging has pushed banks to unload shorter-dated assets.

But demand for 10-year bonds remains strong for matching with longer-term liabilities. Some bond issuers have also cancelled scheduled bond issues in recent months, reducing the supply of long-dated issues.

“The yield-curve inversion won’t persist long-term. The market will undergo a gradual recovery process,” said Xu Hanfei, fixed-income analyst at China Merchants Securities.

Additional reporting by Nan Ma

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