What Caused T-Bond Yields to Increase?
Zhang Ming
/SOURCE : Yicai
What Caused T-Bond Yields to Increase?

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(Yicai Global) Nov. 23 -- Yields on Chinese Treasury bonds have risen sharply since last month against a modest decline in economic fundamentals. What caused T-bond yields to increase? I think this phenomenon can be explained from four perspectives -- demand, supply, inflation expectations and investors' behavior.

Firstly, commercial banks are one of the major investors in Treasury bonds, but their demand for long-term T-bonds has declined substantially in recent weeks, mainly because stronger-than-expected economic growth this year has translated into a steep increase in new credit, and this has certainly affected banks' allocations of funds to the T-bond market.

Smaller banks have much higher financing costs relative to the major national banks, and they will lose money if they invest in T-bonds unless the investments are leveraged (however, the financial deleveraging campaign introduced by national financial market regulators late last year imposed serious restrictions on leveraged investment activities, dampening small banks' interest in the Treasury bond market).

The government has tightened financial regulation since late last year, and the resulting steep increases in yields on money market funds and wealth management products have made financing more expensive for commercial banks, further curbing their enthusiasm for investing in T-bonds.

Secondly, the volume of local government bonds issued this year has remained at a high level, and the volume as a proportion of the total value of government bonds issued year-to-date has gone up compared with previous years. To a certain extent, local government debt has become a substitute for T-bonds.

Local governments issued USD580 billion (CNY3.8 trillion) and CNY6 trillion worth of bonds in 2015 and last year, respectively. The value is expected to be less than CNY5 trillion this year, but newly issued bonds as a proportion of the total volume of local government debts (new bonds and substitution of old debts) has increased this year.

Old debt replacement unlocked credit from banks, and new local government bond purchases will squeeze the liquidity of banking assets. Local government bonds have limited risk exposure and have become a more profitable alternative to Treasury bonds on the supply end.

Thirdly, rising inflation expectations discouraged investors from allocating funds to long-term T-bonds. The consumer price index (CPI) soared from 0.8 percent in February to 1.9 percent last month, triggering concerns that the economic recovery and accelerating producer price index (PPI) growth may lead to a spike in CPI.

China's gross domestic product (GDP) might hit 7 percent in the second half, well above earlier predictions, People's Bank of China Governor Zhou Xiaochuan said at an annual International Monetary Fund (IMF) and World Bank Group conference on Oct. 15. His forecast sparked worries about future inflationary pressure. Higher T-bond yields are a manifestation of the expected increase in inflationary pressure.

Fourthly, institutional investors are now more interested in leveraged short-term bond trading than investing in long-term T-bonds, resulting in a fall in the bond market and a rally in the stock market. The slump in the T-bond market was exacerbated by rising bond yields and bond sales resulting from an upsurge in leveraged stock purchases in the third quarter. 

Asset management firms built long positions on T-bonds and borrowed funds via T-bond repurchases at unprecedented levels in the third quarter, a sign that financial leverage has increased rapidly among funds. Any hint of trouble may disrupt the fragile market structure and spark panic selling among heavily leveraged investors, causing the market to tumble further.

Where will the 10-year Treasury bond market go next year? I think the possibility of a further increase in the 10-year T-bond yield is very slim. It will likely remain at the current level (4 percent) or nudge slightly lower next year.

The author is a researcher at the Chinese Academy of Social Sciences' Institute of World Economics and Politics and the chief economist at Ping An Securities Ltd. [HK:0231]

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Keywords: Bond Market