China Market Stategy: The Most Crowded Trade
Yicai Global
/SOURCE : Yicai
China Market Stategy: The Most Crowded Trade

Volatility in short-term funding costs has disappeared, together with volatility in equity, currency and bonds: Since the stock bubble burst in June 2015, China's short-term funding costs have been kept within a tight range of just above 2%. Steady short-term funding costs have encouraged leverage by borrowing short aggressively while buying longer-term bonds. These heavily concentrated leveraged positions have driven China's 10-year government bond yield to its lowest on record –roughly on par with the lowest in late 2008 (Focus Chart 1).

Problem with such a crowded trade is that any hiccup in the short-term funding costs, or any decline in bond prices can trigger a violent reversal – much like the unwinding of the RMB carry trade after the currency reform that changed the expectation of RMB's one-way appreciation. Already, China's 10-year bond yield has failed to hold at its historical lows.

A change in the Fed's interest rate expectation can set off a surge in funding costs, or a fall in bond price – both detrimental to a crowded and highly leveraged trade. The ECB's failing to expand QE, and Rosengren's metamorphosis from a dove to a hawk bode ill for interest rate outlook in the near term. Brainard speaks on Monday. If rates were kept from rising, then the RMB will be under depreciation pressure. That is, if volatility does not rise in the bond market, it can come from the RMB.

Focus Chart 1: Vol of short-term funding cost flat-line encourages leverage; 10-year yield fails to hold at historical lows.

Source: Bloomberg, Bank of Communications (Int'l)

Inflation, property and commodity prices have risen with money supply; bond yield yet to budge: In the past, PPI, property and commodity prices, M1 narrow money supply, as well as bond yields are closely correlated (Focus Chart2). While correlation is not equal to causation, the reason for such a tight correlation is simple: significantly-expanding money supply should change the growth and inflation outlook, and thus should be reflected in rising property and commodity prices, as well as declining bond prices.

But bond yields have diverged from the other variables in the current cycle. Or bond prices have failed to reflect rising inflation due to commodity and property price pressure induced by dramatic monetary expansion. Such dichotomy of expectation simplied in different assets, together with the crowded trade to leverage up to buy bonds aforementioned, will make bonds vulnerable in the near term. And volatility can spill to other assets, before funds could start the rotation from bonds to stocks.

Focus Chart 2: Money supply, inflation, property and commodity prices have surged, but 10-year refuses to budge.

Source: Bloomberg, Bank of Communications (Int'l)

Market sentiment reaches its historical extreme; correction looming: in our most recent note titled "Consolidation" on August 22, 2016, we documented that sentiment in both US and HK market is approaching its historical extremes. Such euphoric sentiment tends to suggest looming market correction. In our most recent sentiment model update, the Hong Kong market sentiment has surged even higher to its historical extreme, on the back of the news that mainland's insurance companies can now buy Hong Kong stocks via the Connect Program (Focus Chart3). While its good news for Hong Kong, and the removal of the total quota in the Connect program is an important structural liquidity change, insurance companies tend to be a cautious bunch, and Hong Kong H-shares do not offer too much diversification benefits.

In the past, when sentiment is at such heights, it tends to augur for a looming market correction. Shifting US interest rate expectation, potential risks in China's highly leveraged bond market built on the disappearing volatility of short-term funding cost, as well aspotential RMB depreciation pressure can all be catalysts. The US market has suffered the largest single-day correction since Brexit during US Friday's trading, while Asian markets were closed, and yet to have a chance to reflect the expectation changes. Long-term investors should pause for better allocation opportunities ahead in Hong Kong.

Focus Chart 3: HK sentimentat historical extremes, portending a looming correction.

Source: Bloomberg, Bank of Communications (Int'l)

(The Author is Chief Strategist and Co-Head of Research, BOCOM International)

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