Chinese 10-Year Sovereign Bond Yield Surges By Record Amount

Yields on Chinese 10-year sovereign bonds soared by a record 22 basis points on Thursday hitting a 16-month high of 3.4%, prompting authorities to halt trading in some futures contracts. 10-year and 5-year government-bond future prices plunged by a record 2% and 1.2% respectively in early trading, leading yields to soar.

The global market selloff was sparked by comments from the Fed signaling a vigorous clip of interest-rate increases for 2017 and a plummeting yuan. While Wednesday’s announcement that the Fed would raise the benchmark policy rate by 0.25% had been foreseen, its promise to introduce three more next year caught many off guard.  Other factors exacerbating the selloff include concerns of frothy asset markets, accelerating capital outflows, and a liquidity crunch.

“The market was not expecting a change,” said Mike Amey, a portfolio manager at Pacific Investment Management Co., regarding Fed’s announcement to the Wall Street Journal. “You can see that in the reaction in the market.”

The Chinese bond selloff is part of a global trend. US Treasuries have also declined amid expectations of interest rate hikes, adding negative pressure to the yuan and making Chinese bonds all the less attractive to investors.. Germany and Australian government bond yields have jumped by 0.062% and 0.2% respectively. UK yields, in contrast, declined slightly on the back of a Bank of England announcement that it would keep interest rates stable.

Bloomberg adds other factors that have reduced the appeal of debt. Both globally and in China, inflation is expected to accelerate, driving up consumer and producer prices. Moreover, the People’s Bank of China has been driving up money-market rates to spur deleveraging. In response, Chinese banks have begun deleveraging and selling off bond holdings as assets have become more expensive to fund. Bond yields, in turn, have been following money-market rates.

Overall, the short-term outlook on global economic growth has brightened since Trump’s election, given expectations of deregulation, lower taxes, and higher spending. This has also encouraged investors to move away from bonds.

References:

http://www.wsj.com/articles/china-halts-trading-in-key-bond-as-panicky-investors-sell-securities-1481803121

https://www.bloomberg.com/news/articles/2016-12-15/china-s-record-bull-run-in-bonds-is-giving-way-to-a-market-rout

http://www.wsj.com/articles/bond-rout-deepens-after-fed-rate-signals-1481794245

http://www.econotimes.com/Chinese-10-year-bonds-yields-highest-since-Nov-2015-post-Fed-hawkish-outlook-heading-towards-350-pct-mark-451758

 

From ZIRP to NIRP Part I: The Failure of Japan’s Plunging Interest Rates

Japan’s Lost Years and the Introduction of ZIRP

When the Japanese asset price bubble burst in 1991, what was then the world’s second largest economy entered into a period known as the Lost Years. In response to nearly a decade of economic stagnation and fears of a persistent deflationary spiral, the Bank of Japan (BOJ) introduced a zero interest rate policy (ZIRP) in February 1999. The rationale behind the desperate gambit was that the zero interest rates would encourage banks to lend money cheaply, spurring business activity, raising consumer prices, and kickstarting economic growth. In order to inject more liquidity into the market, the BOJ enacted quantitative easing measures in March 2001, buying back Japanese government securities. As a result, the benchmark interest rate on 10-year government bonds dropped to as low as 0.5% at one point.

The BOJ Doubles Down with NIRP in 2016

Instead of stirring from its anemic state, the Japanese economy has been essentially stuck in a 1% growth trajectory for nearly 25 years. As Yale economist Stephen Roach notes, real annual GDP growth fell even further to 0.6% in 2012, when Shinzo Abe became Prime Minister and ushered in “Abenomics.” Instead of acknowledging the failure of its monetary experiment, the BOJ has doubled down, adopting a negative interest rate policy (NIRP) in January 2016. Now, Japanese banks are charged 0.1% for entrusting their reserves to the central bank. Yields on 10-year government bonds dipped below zero shortly thereafter in February.

Moreover, the BOJ has bought up nearly one-third of outstanding Japanese government bonds to no discernible effect. “[Quantitative easing] is at the end of its limits. All you’re doing is building up excess reserves in the banking system,” Marvin Barth, global head of foreign-exchange strategy at Barclays said to CNBC.

Despite aggressive easing and NIRP, deflation has persisted, with core consumer prices falling another 0.5% in July 2016, according to the New York Times. Even with an abundance of extremely cheap money, businesses have refused to borrow more from banks. Rather than rising, the lending rate actually declined to 2.0% in March 2016, following the introduction of NIRP. Part of the issue seems to be that deflation leads to declining revenues, making even cheap loans difficult for businesses to repay. In effect, the BOJ has placed Japanese bankers in an untenable position, squeezed between a decline in lending income on one side and NIRP on the other.

Instead of sparking growth, the BOJ’s financial engineering has repressed the cost of capital, discouraged saving, and incentivized “reckless risk-taking” in an “income-constrained climate”, according to Roach. He warns that this is “treacherous terrain for economies desperately in need of productivity-enhancing investment”, reminding readers that a similar culture of recklessness helped bring about the 2008-2009 global recession.

References:

http://repository.upenn.edu/cgi/viewcontent.cgi?article=1001&context=od_theses_mp

http://www.nytimes.com/2016/09/21/business/international/japan-boj-negative-interest-rates.html

http://www.nber.org/chapters/c0092.pdf

https://www.project-syndicate.org/print/desperate-central-bankers-by-stephen-s–roach-2016-09

http://www.cnbc.com/2016/04/07/what-the-bank-of-japan-boj-will-do-now-that-negative-rates-have-disappointed.html

China’s Debt-Fueled Growth

The Bank of International Settlement (BIS) issued a dire warning earlier this year, opining that a full-blown Chinese banking crisis could be lurking on the horizon. In its September quarterly report, the BIS said that China’s credit to GDP ratio- which measures bank lending against the size of a country’s economy- had reached 30.1, the country’s highest to date. In the context of sluggish economic growth, the risk of individuals and corporations defaulting on their loans rises, increasing the risk of a banking crisis.

China’s soaring debt levels have been the subject of much concern and speculation. Outstanding loans have reached $28 trillion, as much as the commercial banking loans of Japan and the US combined. Total Chinese debt rose to 255% of GDP at the end of 2015, marking a 107% increase over eight years, and currently stands above 260%. Corporate debt alone is 171% of GDP. Worryingly, these figures do not account for the billions in Chinese shadow banking activity occurring outside of the formal banking sector.

According to Ambrose Evans-Pritchard of the Telegraph, these debt levels are “enough to threaten a worldwide shock if China ever loses control”, making China a global epicenter of risk.

Though economists and regulators have entreated China to ramp down its debt, China has relied on this debt to fuel and sustain its economic growth, which has slowed down significantly. In just the 12 months leading up to September 2016, China took on more credit than it did in 2009, when it implemented a great bout of stimulus spending in response to the recession. Property transactions and car sales in China have also ballooned.

The Chinese government is undoubtedly aware of the risk and has sounded warnings about the ballooning national debt through state mouthpieces such as the People’s Daily. However, it has yet to take any concrete action and is perhaps unwilling to deal with the political costs of slowing growth and laying off workers in order to rein in its debt. China’s bank system is also largely state-controlled, meaning they would likely be bailed out in the event of a crisis.

References:

http://www.bbc.com/news/business-37404838

http://www.telegraph.co.uk/business/2016/09/18/bis-flashes-red-alert-for-a-banking-crisis-in-china/

http://www.wsj.com/articles/chinese-debt-soars-into-space-1473755429

http://www.bbc.com/news/business-37114643

China Is Not In A Housing Bubble, Says Macquarie Economist

Contrary to popular belief, the Chinese housing market is not in the midst of a massive bubble, says Larry Hu, head of China economics at Macquarie Securities Ltd., according to Bloomberg. Rather, he contends that skyrocketing housing prices in China’s largest cities are the result of a shortage of supply coupled with consistent demand growth and immigration.

China’s largest cities have experienced drastic surges in housing prices in recent years. According to the New York Times- which reports that “China is in the midst of a dizzying housing bubble”- Shanghai’s average housing price has jumped by one-third in the space of a year, with Beijing and Guangzhou seeing similar increases. Shenzhen, another major Chinese city, has experienced a stunning 60% spike in housing prices within the past year.

At the same time, long-term housing loans (including mortgages) doubled their share of total official bank lending this year, growing from 20% at the beginning of the year to 40% in August, fueling fears that Chinese property is one of the biggest bubbles in history.

However, Hu notes, many smaller cities have not experienced similar housing price gains.“The difference between over investment versus mismatch is the single most important thing to keep in mind when thinking about China’s property sector, as these two views have vastly different implications for investment and government policy,” he wrote.

Hu also observes that larger cities have consistently experienced net immigration with only a limited supply of property entering the market, which leads him to declaim, “this is not a bubble; this is a shortage of supply.” Broadening the scope of focus to include smaller cities yields the surprising insight that housing has become more affordable at the national level, due in part to rising incomes.

As for the largest cities, Hu notes that continued migration into urban areas has maintained a steady floor on housing demand. At the same time, he believes that market-cooling measures imposed by municipal governments ought to mitigate at least part of the risk.

Since September 30, as many as 22 of the largest Chinese cities have passed market-tightening regulations such as raising the down payment on homes to around 30%, raising taxes on additional property purchases, and restricting non-residents from buying property. Such moves are likely driving the decline in China’s home sales that occurred in the first two weeks of October.

References:
http://www.bloomberg.com/news/articles/2016-10-17/what-bubble-china-s-home-prices-driven-by-demand-investment-mismatch

http://www.scmp.com/property/hong-kong-china/article/2029342/chinas-home-sales-decline-governments-market-cooling

http://www.nytimes.com/2016/10/17/business/international/china-home-price-bubble.html?_r=0

http://blogs.wsj.com/chinarealtime/2016/10/12/early-look-chinas-economy-appears-stable-but-watch-the-housing-bubble/

US Stocks Slump On Weak Chinese Export Data

US stocks have slumped following worrying news out of China that its exports in September had fallen 10% year-on-year, marking the sharpest drop since February. Chinese imports also fell 1.9% in September, after rising 1.5% in August. The steep decline in exports was greater than forecast, intensifying long-standing concerns about the slowing growth of the world’s second-largest economy and reflecting weak global demand for goods, which, in turn, bodes ill for global economic growth.

“Weaker-than-expected Chinese trade readings have increased concerns that the pace of global growth will slow further,” said Dennis DeBusschere, a macro research analyst at Evercore ISI, to the Wall Street Journal.

The Dow Jones Industrial Average fell 45.26 points, or 0.25%, to 18098.94 points. The S&P 500 dropped 0.3%, or 6.63 points, to 2132.55, while the Nasdaq Composite Index fell 0.5%, or 25.69, to 5213.33.

Traders sought refuge in government bonds, the yen, and gold, as Treasuries rebounded from a four-month low. The yield on benchmark 10-year Treasuries fell 3 basis points, or 0.03%, to 1.739%, reflecting higher demand. According to Bloomberg, the US Treasury sold $12 billion of 30-year debt on Thursday. Conversely, raw materials and energy stocks fell out in anticipation of weakening demand.

The weak data coming out of China has precipitated some doubts as to whether the Fed will indeed raise interest rates by its December meeting, though the market-implied probability rate of such an eventuality is still 66%. The consensus among traders and investors is that the Fed will proceed with raising the interest rate, despite the news.

“It’s going to take some pretty lousy data to persuade the Fed to not raise rates,” said Art Hogan, of Wunderlich Securities to Bloomberg. “The Fed’s letting us know that December is something they have to be talked out of, not into.”

References:

http://www.wsj.com/articles/global-stocks-down-after-weak-china-export-data-lower-oil-1476344506

http://www.bloomberg.com/news/articles/2016-10-12/dollar-near-6-week-high-versus-yen-after-minutes-crude-declines

http://www.forbes.com/sites/timworstall/2016/10/13/china-export-fall-knocks-global-stock-markets-because-of-what-it-says-about-the-global-economy/#52b4b7c633aa

http://www.marketwatch.com/story/us-stocks-open-lower-following-china-trade-data-2016-10-13?siteid=bnbh