Overview
Why have China government bonds (CGBs) been underperforming? Yields have been propelled upward by a combination of factors. Leading economic indicators have been surprising to the upside as China’s business activity normalises. Producer price inflation (PPI) increased year-on-year in June, suggesting that deflation may be coming to an end. There is also the prospect of much higher government bond supply. And finally, the People’s Bank of China (PBOC) took steps to curb arbitrage opportunities linked to low funding costs and high-yielding structured deposits, which resulted in a slight tightening of monetary conditions.
But we think there is likely a limit to how far yields can rise from here. First, hopes for a full recovery in GDP growth rest partly on low funding costs. At some stage, higher government bond yields will begin to undermine the stimulus and weigh on growth.
Secondly, PPI deflation may end, but core measures of consumer price inflation are only slightly positive and remain at their lowest level in nearly a decade. Real interest rates are already high as a result.
Lastly, we’re seeing a reduction in structured deposits, showing the authorities are so far successful in reining in this source of credit. In the third week of June, PBOC data showed the amount of outstanding structured deposits fell by RMB 300 billion (around $43 billion) after having increased for four consecutive months. Further tightening measures may not be needed.
These factors could end the recent period of underperformance for CGBs versus the other major government bond markets, which could provide a good entry point for investors. CGBs offer an attractive nominal and real yield, have demonstrated defensive qualities when equities sell off, and still stand to benefit further from structurally increasing foreign ownership.
