China’s yield premium over Treasuries is rapidly shrinking, and is now the smallest since April

By BLOOMBERG

HONG KONG • China’s bond traders know all too well how painful it is when markets suddenly start pricing in higher inflation. But at least for them, it seems to be in the rear-view mirror.

Treasuries are gripped in their worst start to the year since 2009, with 10-year yields spiking toward 3% and contagion spreading to equities.

In contrast, sovereign yuan bonds are holding steady following last year’s sell-off.

That means China’s yield premium over Treasuries is rapidly shrinking, and is now the smallest since April.

“We expect the yield gap to narrow this year,” said David Qu, an economist at Australia & New Zealand Banking Group Ltd. “Chinese government bond yields already had a spike in 2017 and we expect its rise to be slower — that will be a contrast to the speed of increase in US Treasury yields.”

The US bond sell-off this year should look familiar to Chinese investors: Yields spiked to three-year highs on the mainland in November on expectations for faster inflation and an official deleveraging campaign. Still, the sell-off was relatively orderly, and didn’t feed through into other local asset classes, nor into world financial markets.

Now, Treasury yields are near a four-year peak on inflation signs and uncertainty about US Federal Reserve (Fed) tightening under new chairman Jerome Powell, who suggested last week that the Fed would push ahead with gradual rate hikes even as it remains alert to financial stability risk.

The 10-year yield has risen 53 basis points this year to 2.93% yesterday, with the turmoil spreading to US stocks earlier this month and then on to spark a global meltdown.

The developed world’s bond markets are belatedly responding to higher inflation and better economic data, whereas China’s curve already absorbed the change from deflation to inflation over the past year, according to Jefferies Group LLC. The yield on 10-year Chinese debt was steady at 3.9% yesterday.

China’s government can flex its muscles during bond routs like last year’s to discourage banks from offloading the securities, preventing any contagion effect for equities, said Richard Harris, Hong Kong-based CEO of Port Shelter Investment Management.

While large international institutional investors may not switch out of Treasuries into Chinese debt because of other risks associated with the onshore market, some hedge funds may take advantage of the narrowing yield gap trend, as will other investors who have endogenous demand for yuan, he said.

Goldman Sachs Asset Management sees US 10-year yields rising as high as 3.5% in the next six months as the market prices in a steeper pace of Fed tightening. The asset manager expects four hikes this year, exceeding the median projection from Fed policymakers for three.

When the Fed raised its benchmark by 25 basis points in December, China boosted borrowing costs by just five basis points.

The signs are certainly there that the US central bank won’t be deterred from rate increases by the market sell-off.

As well as Powell’s commentary, outgoing New York Fed president William Dudley recently judged the drop in stocks to be “small potatoes”.

And Dallas Fed president Robert Kaplan said market volatility may be “healthy”.

“The Chinese central bank led the way in tightening monetary conditions and China government bond yields responded accordingly — in contrast, US Treasury yields have only recently responded to the prospect of tighter policy and potentially higher inflation,” said Mark Reade, desk analyst at Mizuho Securities Asia Ltd in Hong Kong.